Adam Levitin writes at the ForeclosureBlues blog about the Ibanez decision in the Supreme Judicial Court of Massachusetts (pdf via Creditslips blog), handed down last Friday.  (Actually, I think Adam’s post originated at CreditSlips.) This is an important decision in addressing the exceedingly vexed and, as Megan McArdle notes, highly technical legal questions surrounding the property issues – chain of title, etc. – in foreclosures on mortgages that have been securitized.  Levitin offers this assessment of the holding in Ibanez (I recommend also his article with Anna Gelpern, Rewriting Frankenstein Contracts):

The Ibanez case itself is actually very simple. The issue before the court was whether the two securitization trusts could prove a chain of title for the mortgages they were attempting to foreclose on.

There’s broad agreement that absent such a chain of title, they don’t have the right to foreclose–they’d have as much standing as I do relative to the homeowners. The trusts claimed three alternative bases for chain of title:

(1) that the mortgages were transferred via the pooling and servicing agreement (PSA)–basically a contract of sale of the mortgages

(2) that the mortgages were transferred via assignments in blank.

(3) that the mortgages follow the note and transferred via the transfers of the notes.

The Supreme Judicial Court (SJC) held that arguments #2 and #3 simply don’t work in Massachusetts. The reasoning here was heavily derived from Massachusetts being a title theory state, but I think a court in a lien theory state could easily reach the same result. It’s hard to predict if other states will adopt the SJC’s reasoning, but it is a unanimous verdict (with an even sharper concurrence) by one of the most highly regarded state courts in the country. The opinion is quite lucid and persuasive, particularly the point that if the wrong plaintiff is named is the foreclosure notice, the homeowner hasn’t received proper notice of the foreclosure.

Regarding #1, the SJC held that a PSA might suffice as a valid assignment of the mortgages, if the PSA is executed and contains a schedule that sufficiently identifies the mortgage in question, and if there is proof that the assignor in the PSA itself held the mortgage. (This last point is nothing more than the old rule of nemo dat–you can’t give what you don’t have. It shows that there has to be a complete chain of title going back to origination.)

I don’t think it is too much to ask the financial services industry to follow the rules on title and transfer.  I have been surprised by how many people, including lawyers, have simply said that intentions were clear even if the requirements of transfer were not followed.  I don’t think that’s good enough, not for the past and less so going forward.  There are reasons why we treat transfer of property, and real property and associated rights, differently than contract.  I have no doubt that things are much more complicated than I imagine, but with computerization and technology, on a regulatory reform basis, shouldn’t we be able to do a whole lot better than this?

What would a rational, going forward system of title and transfer look like – tell me in ways that take advantage of technology as it is, not some imagined possible world, and tell me ways that match up to things already being done in the securities industry.

While everyone is at it, tell me how we should address the Frankenstein hangover of the past.

Flying to and from meetings this week at the Hoover Institution, I re-read David Skeel’s brand-new book, The New Financial Deal: Understanding the Dodd-Frank Act and Its (Unintended) Consequences (Wiley 2011), for a second time. I am even more impressed with this book the second time around, and I believe that it is one of the short list of essential books on the financial crisis and the regulatory aftermath. If you have any interest at all in these topics, this is a book to give serious consideration to reading.

The New Financial Deal is very far from being a dense, specialist book readable only by a lawyer, or law professor, or bankruptcy or finance expert. You might guess from the title that the book is a technically useful, but, for the general reader, impenetrable commentary on the Dodd-Frank bill. After all, the bill itself runs several thousand pages of impenetrable legislative language and Skeel himself one of the country’s leading bankruptcy scholars. It might seem from the title that it is simply an unpacking – at the technical level – of what Dodd-Frank says. Technical experts can benefit enormously from such unpacking, but not so much the policy person or general reader.

But it’s not that. On the contrary, Skeel’s considerable achievement in this book is to write accessibly and persuasively about the Dodd-Frank bill. Skeel is an an admirably clear and graceful writer on very difficult topics; it shows in the sentence by sentence prose, but equally in the overall organization and selection of topics for discussion. It doesn’t seek encyclopedic analysis of the zillions of legislative provisions, but instead makes a judicious and profoundly informed selection of the main achievements (and lack thereof) of the legislation. It then succeeds better than anything I’ve read on the topic of financial regulatory reform at placing this in the context of “political economy.”  I don’t mean politics in the day to day sense, but instead the interaction of these financial rules with the political process and the intended and unintended consequences.

II

Corporatism and Brandeis-ism, and the New Resolution Authority

The fundamental reform measures of the Dodd-Frank bill correspond roughly to financial institutions and financial markets. As to institutions, Skeel examines the new mechanisms designed to address systemic risk and the mechanisms created to address supervision of those institutions both before a crisis and after the effective failure of an institution.

The political economy of this institutional supervision is given as two alternative tendencies in American economic regulation. One is the “corporatist” tendency to create a quasi-partnership between government and the largest corporations, so that government is able to exercise in some respects closer control over those corporations but also bending them to its political will – but losing the distance between regulator and regulated that usually makes regulation more effective and more importantly ensuring that those privileged institutions will not be allowed to fail, at least if they play political ball.

The other is what Skeel astutely calls the “Brandeisian” tendency to break up the largest financial institutions so that they cannot become too big, or too interconnected, to fail. He notes – this might surprise some readers – that the New Deal, however empowering government in many matters, was essentially Brandeisian on the treatment of banks, insisting on confining them in function (Glass Steagall, etc.) and in many other ways.

The tendency adopted by both the Bush and Obama administrations has been firmly corporatist. It is evident in the definitions in the Dodd-Frank bill of institutions formally designated as systemically important, but also thereby too big to fail. The corporatist tendency is also a founding feature of Freddie and Fannie, and the extraordinarily politicized activities of both firms as integral to their business models – both buying off Congress and yet chanelling the political will of administrations and bureaucracies – is what Skeel suggests will result from the corporatist model, quite apart from the problem of a lack of moral hazard leading to a regime of permanent bailouts.  (Too big to fail is sometimes correctly criticized as really meaning “too systemically interconnected to fail.”  This is right, but that translates to systemically interconnected firms that, with respect to this feature of risk, are “cartelized” as though they were a gigantic, if loosely, connected enterprise.)

Skeel’s other fundamental point concerning institutions is that the nature of regulatory authority is essentially unconstrained discretion. It is not discretion of the kind exercised by a bankruptcy judge – gap filling and interpretive and discretion existing only for defined issues, existing yes, but within a tightly bound box. It is, instead, one single non-discretionary norm – that certain institutions are too big to fail – but that everything else is discretionary (I exaggerate some, but it helps illustrate the point). It is discretion not as filling in the inevitable gaps, but instead deliberately widening discretion to cover as much as possible. Though Skeel does not frame it this way, I would describe it as “discretion as strategic ambiguity” in which the rule of law is set aside for the purpose of making it impossible to know how you will be treated: allowed to fail in some cases, taken over in others, not allowed to fail and not taken over, with no standards for knowing what results in what. This is the criticism that Skeel makes of the new “resolution authority” for institutions.

Skeel’s deepest normative point, however, is that the regulatory model deliberately undermines the rule of law – particularly the careful establishment of judicial discretion contained with bankruptcy’s special rules of law. Instead, the Dodd-Frank model finds predictable rule-based regulation inapposite to the task at hand and seeks to displace it by deliberate uncertainty, on the one hand, infused with government’s political preferences, on the other. The political preferences are analyzed against one of the most provocative but also, to my mind, persuasive turns of Skeel’s argument: to show how the auto bailouts are the template for the future bailout regime of the financial institutions. The short, accessible yet expert discussion of the treatment of senior creditors in the auto bailouts is outstanding – but most important is how Skeel shows that this, rather than the earlier bailouts in the financial services industry, is the template for future behavior under Dodd-Frank. That, and Fannie and Freddie.

III

Discretion and the Rule of Law

With respect to the question of unfettered, radical discretion, Skeel spends less time, so I want to extend the analysis a bit. As Skeel notes, the exercise of radical discretion by Paulson, Geithner, and Bernanke in the financial crisis raises questions of executive power and authority. The discretionary response in the economic crisis naturally invites comparison to national security crises, with regards to the power of the executive. Eric Posner and Adrien Vermeule have offered the strongest view that in moments of emergency, the executive is and must be unconstrained and unbound, whether in national security or the economy.

To be clear here – what I say in this next two sections concerns the kinds of purely discretionary actions taken by Paulson, Geithner, and Bernanke at the moment of high crisis, what Davidoff and Zaring called “regulation by deal.”  Dodd-Frank, in Skeel’s view (as I read him and in mine), goes quite a ways toward enshrining that discretion, particularly with regard to what the alternative bankruptcy regime would do.  It’s also true that in response to criticism, the final version of the bill cut back some of the discretionary elements, along with some of the more obvious invitations to enshrine the bailout regime. I’m not suggesting that Dodd Frank enshrines pure discretion to the full extent that Paulson et al. exercised it during the most crucial moments of the crisis – but that it moves further that direction than back toward a rule of law based system of which bankruptcy is exemplary.

So, to return to Posner and Vermeule’s thesis, I do not think that it is true of the executive in matters of the economy, and it does seem to me that the comparison of national security and the economy in moment of crisis is fundamentally inapt.  Why?

In the briefest terms, the actors in the national security crisis are fundamentally enemies, to whom we want to do damage. In the economy, they are friends, whom we want for all our sakes to prosper, but within a structure of the rule of law; we wish them regulated, not harmed as such. It is a category mistake to treat together executive discretion to inflict harm intended to destroy people and an organization, and enforcing regulations that will allow a firm to “fail” and “be destroyed.” The nature of the discretion exercised is different because “destroy” means something utterly different in these two contexts; they are not both instances of executive discretion in a usefully similar way.

(Moreover, in a sense, the national security executive who seeks to harm the enemy is conceptually constrained in a way that is not true of the “national economy executive.” Why? Deliberately inflicting harm (I might change my mind about this) is inherently less discretionary than trying to do the right thing by the economy, which is supposed to be in the hands of largely private actors. One does not wage war upon those private economic actors; one stands above them to create a set of neutral market structures. If one gives the executive unfettered discretions at moments of meltdown, that discretion – because the nature of economic stability and recovery and growth is inherently more contested and contestable, legitimately so, by all these parties, than national security, which is a far more “one way” activity in time of crisis. But I might well change my mind about this.  Added:  I probably am changing my mind about this as I write, but I’ll leave it in nonetheless.)

IV

Permanent Radical Uncertainty and Strategic Ambiguity as Discretionary Policy

In describing Skeel’s complaint about discretion displacing the rule of law, the point is not that emergencies set aside rule of law rules, as Posner and Vermeule’s model both describes and urges. It is, rather, in the nature of the discretion sought.  In the economy, in order to influence parties with utter discretion, you want the absolutely contingent nature of that discretion known in advance; it is not a power that you invent in the emergency, it is, instead, that all parties know (in advance, from the very beginning, as a permanent feature of the system), that in an emergency, all bets are off.  It comes to the surface and asserts itself only in an emergency, but the basic norm authorizing this radical contingency behavior is known in advance.  That’s part of what gives it its bite, and the slogan might be … “Radical uncertainty – you can plan on it!”

Is it consistent with the rule of law to have a “rule of law” that applies in an emergency, although announced as a rule in advance, to say: “Here’s our rule … there is no rule”?  I don’t think so, at least not in matters of the economy.  National security raises different issues, as noted above and expanded in the discussion below.

So to summarize this observation.  It’s not that the executive must have power to respond, however circumstances might dictate. That is not the nature of financial crisis and its response. It is, rather, that the response to the crisis requires (and to be really successful requires long before the crisis, as a permanent contingency) radical uncertainty about how the executive will act. Induced, strategic uncertainty is the point. The problem, in other words, is not simply one of the “unfettered executive” or, in Posner and Vermeule’s words, the “executive unbound.”  It is that the nature of the discretion requires, in order to do what it is designed to do, that it be strategic and radical uncertainty, not merely at the moment of crisis, but permanently, during the times before, so as to constrain economic actors through fear of uncertainty.

In the case of national security, where the actors are the “bad guys,” this might often be a good idea. Uncertainty raises costs of action and makes advance planning much more difficult. Strategic ambiguity with regards to enemies is often a useful strategy. But the reason is that they are enemies, and the purpose is to inflict costs. In the case of the economy, the actors are different. They are friends. We want them to grow and flourish and do well – and to regulate them to those ends. The regulation is important, but the purpose is not to damage them. We don’t want uncertainty, because we want to lower costs to them as economic actors in making forward planning. The rule of law enables that by providing greater certainty – assuming, as is hard to assume now in important financial matters, that it will be followed in the future.

I am putting Skeel’s point differently from how he does and extending it in important ways. In particular, I am emphasizing the reliance upon strategic uncertainty as the regulatory mode. I believe he would agree, but would certainly be interested to get his reaction. In any case, national security and law theorists have many compelling reasons to read this book, alongside Posner and Vermeule’s Executive Unbound, about which I’ll write more once I’ve read the final version.

V

Markets and Derivatives

The book’s second main substantive topic is the regulation of markets, and in this he focuses upon derivatives. This is astute, because amidst the welter of financial markets one could talk about many things.  But by taking derivatives in a broad enough sense, and by narrowing upon the Dodd-Frank bill’s principal regulatory move with respect to them – exchange clearing – he gets to the heart of the markets questions.

Herein lies the central problem of Dodd-Frank in a nutshell, however. The bill establishes a requirement of both exchanges upon which standardized derivatives will be traded, and a clearinghouse requirement to centralize clearing and create a centralized counterparty to the trades. By itself, and leaving aside various arguments over ways in which it will raise costs to Main Street bread-and-butter hedgers, most (nearly everyone but Highly Interested Parties) would agree this is a sensible reform. But in the context of the overall provisions of Dodd-Frank, the effect, Skeel carefully explains, is likely to be creating more bailouts, not fewer.

As I think I said in some earlier post on this, a sensible reform on its own becomes, in the context of Dodd-Frank’s embrace of too big to fail, a doubling down on risk. It provides a central address to which players can send their risk, and know that the government will have to stand by the clearinghouse. The clearinghouse, intended to force market players to internalize their risks by forcing them to monitor one another and set realistic levels of margin and other insurance, instead offers yet another avenue to a government bailout. Instead of containing risk, the specific provisions of Dodd Frank, in the context of an embrace of too big to fail overall, leverage rather than reduce risk in the financial system.  Skeel’s discussion of how a clearinghouse failure might occur and what it would mean is sobering.

VI

The Consumer Protection Provisions and Securitization

Skeel is sympathetic to the consumer protection features of the bill – perhaps more so than one might have anticipated. I don’t understand those aspects very well, so I will skip over them. However, it is noteworthy that this section addresses the question of securitization as such, and primarily to make the point that modification of individual loans is darn hard to do, in part because of the technical process of “slicing and dicing” the mortgages underlying the rest of the edifice.

My colleague Anna Gelpern and Adam Levitin have analyzed this phenomenon in their “Frankenstein Mortgages” article.  The end result, as many news accounts have observed, is that only a tiny handful of mortgages have in fact been modified at the retail level. I believe Skeel’s basic observation about securitization can be summed up by saying that it is not, by itself, the leading problem. Far more consequential is the structure of derivatives built on top of (MBSs), but also used to insure (CDSs), all the rest. Which is to say, it is not the securitizations as such, but leverage (and a variety of other problems I skip over). However, securitization reform requires balancing off two considerations.  Diversification is an enormous benefit; but it does entail the loss of an actor with a clear incentive to deal with the underlying credit issues in issuance or monitoring. The requirement that the securitizer keep some skin in the game is a good one, even if it is hard to figure out how high to set the amount.

VII

La vida es sueno

The New Financial Deal is peppered throughout with important, but deliberately not sweeping, ways to improve the Dodd-Frank bill. These are crucially important, but I won’t try to run through them here.  Although one merits special attention – removing the special exemptions for derivatives in bankruptcy.  In general, as Skeel notes, his proposals for reform can be called “bankruptcy to the rescue.”

That perspective is consistent with something I should have observed back at the beginning – viz., the book’s starting point is that the “received wisdom” for how we came to have a financial crisis is dead wrong. The CW says that it began with the terrible mistake in not rescuing Lehman; everything fell apart from there.

Skeel says that this gets it exactly backwards – the real problem lay in rescuing Bear Stearns before it. Bear could easily have been handled in bankruptcy, he says, and the signal sent, and reinforced by regulators, that Lehman’s managers had to work out a sale immediately or face collapse with no rescue. This is a compelling re-conceiving of the usual wisdom, and one that I find persuasive.

I would add to Skeel’s account that the regulators were themselves living in a bubble, in a dream. As Bear Stearns unfolded they seem to have believed that it, the crisis, was the dream and a bad one.  Whereas the parties themselves were all living in a dream.  It led them to think that if they simply did what they had been doing since the 1990s, flood the place with money, undertake some rescues, call a do-over and a re-set and a re-boot, we could would awaken back to a normalcy of low hills and gentle valleys.  Whereas the longer run reality is that the ups and downs are steeper, and more brutal – something more like the Sierra Nevada, the Owens Valley, and the chasm of Yosemite, deep in snow, over which I have just flown.  Actually, what I have just flown over, I see below me, is Donner Pass.  Where otherwise pretty good people get desperate and  … eat each other.

The legal powers of the Fed – and their limits, regulatory, statutory, and Constitutional – are obviously a question of importance today.  The financial crisis, the response, and the continuing unemployment rate make the question of the Fed’s mandate, independence, and limits germane in a way that has only rarely been true in the economic history of the US since creation of the Federal Reserve.  Consider one of the latest arguments – will the Fed move to monetize the fisc, meaning the fiscal deficits of states and municipalities, as a source of – not liquidity of last resort – but instead as a provider of solvency?  A George Will column expressed the concern, set against public pension issues, this way:

People seeking backdoor bailouts hope that the fourth branch of government, a.k.a. Ben Bernanke, will declare an emergency power for the Federal Reserve to buy municipal bonds to lower localities’ borrowing costs. This political act might mitigate one crisis by creating a larger one – the Fed’s forfeiture of its independence.

Will obviously has a side in this debate, but that is not what interests me; it is that the law governing central banking is up for serious debate in a way that is historically not often true.  Please leave aside any comments as to the policies involved, good or bad.  I am interested in understanding the underlying sources of law and regulation at issue here.  If the Fed were so to act, are there legal limits on the ability of the Fed to act in this way – and does it matter one way or another, as a matter of law, if Congress has declined to provide a fiscal bailout?

I am also particularly interested in anything offered somewhere in the law school curriculum on comparative central banking, in universities here in the US or elsewhere.  Again, same interest in curricula, syllabi, readings, etc.

Update:  Thanks for the responses below, they are very helpful, and I’ll be in touch with Eric and some others mentioned below.  I’ve deleted some comments that are not relevant to my inquiry; I’d like the comment thread to be useful to people who are searching for the same materials I mention in the post, and don’t want other things there.  Also, I should add that I’m not actually contemplating teaching a class on this topic – I don’t know whether there is enough material for a course on the law of the Fed or not, although I do think that a comparative central banking course surely offers sufficient materials.  Rather, I would like to know more about the area substantively, and this seemed like an easy way in.  As well as helpful to others looking for materials in the field.  Thanks everyone.

After all, why should any of these leading market participants believe at this point that the government would allow the central clearinghouse to burn down in a crisis?  And if they don’t believe that, then what is their incentive to set terms that will adequately address the risk as a matter of private ordering of fees, margin, whatever form of insurance the central risk-clearer needs? Having a central clearing counterparty is a great idea – if it and the actors that run and control it have the private incentives to make sure it is not a mechanism for accumulating and compounding risks.

Presumably the answer is that government regulators will set those requirements and solve the problem.  But the general theory of financial regulation used to be that systems would be monitored for risk-taking, after private parties (with well-structured incentives forcing them to internalize the risks) had already made the first round of risk-decisions.  Regulators would be kicking the tires for safety and soundness, as a second line of regulatory defense, not the first.  I am an admirer overall of Gensler’s efforts, but he cannot be Batman to Financial Gotham.  The peculiarity is that a structure that ought, in principle, to reduce risk might wind up leveraging it.  The clearing house might turn out to be the one address market participants need to send their unwanted risks.

ps.  Here are a couple of possible unaddressed risk scenarios:

• The clearinghouse turns out to be pretty good at managing fairly predictable, day to day risks.
• The clearinghouse turns out to be okay at managing day to day risks, but is not good at identifying or dealing with risks that arise over a long run of time from relatively minor distortions in the system’s incentives, perhaps arising from conflicts and complexity of those who own and run the clearinghouse and their other activities, perhaps other things.  Those distortions over time start out small but turn out to be large and compounding and structurally invisible or discounted until they blow up.
• The clearinghouse’s private managers turn out to be good at managing day to day risk; Mr. Gensler, et al. turn out to be okay at forcing the clearinghouse and its private owner-managers to internalize risks caused by apparently minor distortions as they arise, because the public regulator is pretty good at spotting conflicts, even amidst complexity, and has an institutional mandate to pry apart conflicts of interest, even if it angers the banks.
• The system centralizes tail-risk, radical uncertainty.

If the clearinghouse system could achieve the third as its long term behavior, then I think it is on balance a good move.  The fact that the fourth exists is not a reason not to create an otherwise rational scheme of regulation; if it is, nearly by definition, unforeseeable with sufficient specificity to prevent it from happening, that might be a pretty good definition of what the role of institutional and liquidity provider of last resort is supposed to be.  One of the peculiarities of financial regulatory reform, after all, is that one can always object to nearly everything on the grounds that there is radical uncertainty and there might be unforeseen and unpredictable consequences … so better not do that.  Or that, or that, or that.  But of course not doing anything at all is also doing something with equally radical uncertainty.

I sometimes think that we should all re-take Philosophy 101 in Skepticism and Rationality in embarking on academic discussion of financial regulation and risk.  What is the appropriate kind of skepticism about the limits of our rationality in creating regulatory systems for complexity?  Sometimes I ask a question about what I think is a fairly concrete, rationally predictable thing in financial regulation – close, in my mind, to asking what the weather is likely to be tomorrow – and get an answer back that sounds a bit too much like, “We cannot say, because after all we have no proof of the existence of the external world.  La vida es sueno.”

Hmm, I think, vale. It is a little like what the late philosopher of mind Rogers Albritton referred to as the skeptic’s devious willingness to shift to another existential form of skepticism just when we thought we had answered him on this one, but not quite saying that he had shifted skeptical grounds.  (“Shapeshifting skepticism,” one might call it.)  We ordinarily wouldn’t worry much about this possibility, obviously – except that many people think we just experienced this radical uncertainty, come to pass, in the financial crisis.

Other people think, of course, that it was imminently foreseeable, if not because of the actual (disputed) causes, then because the procedural combination of complexity, conflicts of interest, and moral hazard driven complacency strongly implied something that could not go on as it was going – a matter of a visibly flawed process, so to speak.  If that is one’s view, however, then the lurking question of number four is less whether the tail risk was actually foreseeable and preventible, but instead whether relations of complexity of systems, conflicts of interest, and attendant complacency meant that no one had enough at stake to find it.  In which case, the prescription for public regulators in regulation is less to try and find it, than to give all those other, deeply interested, but also potentially deeply conflicted, parties reasons to overcome their complacency and conflicts, and have them dig through the complexity to find it, instead.

(Moreover, the point of providing liquidity as the provider of last resort in number four is in order to allow markets to make an orderly path to price discovery that is not simply a strategically forced run on the banks.  It can’t magically remake insolvency into solvency except by fiat – or fiat money.)

The second time around reading it was not for nuggets, but instead to try and understand the whole thing, as a comprehensive thing.  I realize that this makes little sense given that it is not a “thing” but an agglomeration of many things, some of which fit together and some of which don’t.  But this second time, I read it with some research help, and more importantly with the several hundred page bill summary to hand.  This was partly to understand the bill, but partly to get a reality check, at least for parts of the bill in which I have a good grasp of the issues, whether the summary is accurate as to the bill and its impacts.  I can report that for at least sizable chunks of the bill where I think I’ve got a strong sense, the summary is outstanding, and unless someone points out to me big areas where it is not, I’d urge those working with the bill to go to it.  I am open to correction on this point, if you are genuinely expert in these matters.

My one graf takeaway on the bill is this, however.  Parts of the bill have little relevance to the financial crisis, although they might still be part of an overall package of reform of financial regulation; one can always tell a story about how they have an impact on crisis through accumulations of bad issues, but realistically, whatever point they might have or not have – the consumer protection provisions come to mind – they are adjunct.  If the underlying rationale and point of the bill is to alter the regulatory conditions that allowed for the development of the crisis, then it should be fundamentally about addressing systemic risk, too big or too interconnected to fail, and attendant moral hazard; complexity, complacency, and conflicts, as Steve Schwarcz says.  As a substantive matter, however, the bill in total effect does not address too big or too interconnected to fail as a matter of private ordering, and so has the regulatory authority assume the moral hazard.  Which leads to this dismaying conclusion:  There are important parts of the bill that would make a great deal of sense (leave aside various particulars), in a regulatory environment that properly put the moral hazard of systemic risk on the private actors.  To take one example – and leaving aside the WSJ editorial today about Main Street’s risk management issues – the proposal to move OTC standard derivatives onto centralized clearinghouses that would both provide greater transparency and reduce the scary information asymmetries and provide for centralized clearing.  Great idea, with appropriate tweaks, in my view – until it becomes clear that because the bill does not put the risk burden on the private actors ultimately – does not force the private players to internalize their risks in derivatives trading, the clearing house and ultimately the taxpayer serve as the guarantor of last resort.  The effect of an otherwise sensible regulatory change in the derivatives market, under conditions in which moral hazard has not been addressed, is not to reduce systemic risk, but to leverage it up by centralizing it in the ultimate public counterparty.  The ironic result of the bill, in other words, is that by failing to address the systemic risk problem other than by telling the Fed and the Treasury and the “council” to figure it out, and so leaving too big or too interconnected to remain in place, otherwise sensible regulatory reforms that should reduce risk and increase transparency and informed pricing instead turn out to ratchet it up, leverage it up, for the ultimate government counterparty of last resort.  That’s not what I was hoping for.

Long graf, yeah, I know.  But while I await Skeel and Cowan’s book, I am willing to be told that this is not correct and I don’t understand what the bill does.  However, if you’re going to correct me, please confine discussion to the main issue here, which is the overall impact of the bill, taken as a whole, as defined by the systemic risk question.  I should also note, as I have earlier, that a very impressive theoretizing of systemic risk has just appeared from Steven Schwarcz and Iman Anabtawi, Regulating Systemic Risk.  It is the most striking attempt to give an account of systemic risk that I have seen in several years; what it consists in and how it propagates.  (I re-read it yesterday, and looking at the turmoil in the eurozone, wondered whether this same account could be applied to what we might call “sovereign systemic risk.”  I wonder.)

UPenn law professor and corporate finance and bankruptcy specialist David Skeel has an important article in this week’s Weekly Standard talking about the possibility and utility of bankruptcy for states.  The article argues first that a new chapter for states in the Federal bankruptcy statute would be constitutional, and then turns to argue, second, that the benefits to the public would be considerable:

When taxpayer-funded bailouts are inserted into the equation, the case for a new bankruptcy chapter becomes overwhelming. And it’s a case for Congress to move now on the creation of a state bankruptcy law.

With the presidential election just two years away, the pressure to bail out California, Illinois, and perhaps other states is about to become irresistible. As we learned in 2008 and 2009, it is impossible to stop a bailout once the government decides to go this route. The rescue of Bear -Stearns in 2008 was achieved through a “lockup” of its sale to JPMorgan Chase that flagrantly violated corporate merger law. To bail out Chrysler and General Motors, the government used funds that were only authorized for “financial institutions,” and illegally commandeered the bankruptcy process to give the car companies a helping hand. There is, in short, no law that will stop the federal government from bailing out profligate state governments like those in California or Illinois if it chooses to do so.

The appeal of bankruptcy-for-states is that it would give the federal government a compelling reason to resist the bailout urge.

This is an important piece of public advocacy by a leading scholar, agree or disagree with its two main contentions, and repays close reading.  (The illustration above is a thumbnail from the WS.)

Update:  Thanks, Glenn, for the Instalanche – but also for the very interesting updates at Insta, including some important comments and emails that I encourage VC readers to check out.

Also, Co-Conspirator Todd notes above the Stanford Law School conference on the Constitution and the Financial Crisis, at which both he and I spoke a couple of weeks ago.  It was a great conference, and CSPAN, as he notes, has put online a couple of the sessions.  One of them includes a discussion of bankruptcy and the auto bailout, and the lineup includes both Todd and David Skeel, UPenn professor and author of the above Weekly Standard article.

I have not tried to comment on the constitutional questions, as I do not have the expertise to do so.  But I wanted to make a different kind of point about bankruptcy processes that involve quite important areas of judicial discretion – equitable discretion in a generic sense – within a given structure of rules that can force creditor-parties who otherwise would not be likely to overcome collective action problems to come together.  Leaving aside constitutional questions that I am not competent to address, I favor as a policy matter something like Professor Skeel’s position.  Likewise, I favored bankruptcy as the proper process in the auto bailouts, among others.

That said, I express one caution (I’ve put up a longer version of it as a separate, later VC post).  When in a crisis, or contemplating responses to crises, we naturally look around and see an existing mechanism that seems to have worked pretty well.  Bankruptcy judges and courts, for example, in parts of the financial crisis.  We think that they have worked out pretty well how to cabin judicial equitable discretion in these matters within rules, precedents, codified law, etc.  So we collectively think, let’s assign them this big new thing – sure, it’s kind of a stretch (such as bankruptcy for states), but these mechanisms and actors have a stable procedural path that has been well worked out and well trod.

The risk here is that we do not take into account the way in which the addition of this new social and political and legal task is not just stretching existing institutions – taking on these new functions involves addressing whole new categories.  Bankruptcy of sovereign entities, for example.  It is categorically different, and has the effect of altering the nature of judging, because it just is, by its nature, political in way that no commercial activity is.  It alters the nature of discretion, the role of the judges, and how the judges see their role – how they cabin their discretion within a body of rules.  It alters the terms of legitimacy when they shift from purely commercial and private players to sovereign actors.

Now, I describe this as a risk and I perhaps overstate by calling it a category rather than a stretch.  After all, municipalities have been in these processes before, and states have defaulted before, and so an existing system might well simply grow into this role without warping it out of identification.  But it is a risk.  At a minimum, it should not be assumed that the mechanisms established by law for dealing with private actors within a structure of sovereign law can automatically work with sovereigns themselves, without altering the notion of “cabined discretion.”

Finally, note that this problem is by no means limited to this kind of financial crisis and bailout problem.  The same conceptual problem arises whenever judges are proposed to be tasked with some kind of new activity – precisely because we think that they embody both legitimacy and discretion.  Discretion that carries legitimacy because it is limited in many ways.  Think about arguments that we could have federal judges giving advance and necessarily secret review of targeting decisions for drone warfare attacks; or issues related to detention and rendition before the fact; or many other related issues.

The assumption is that judges have this legitimate discretion as an attribute of being a judge and that it can be carried around from political activity to political activity as an independent quality.  But of course it does not work that way.  Legitimacy, and equitable discretion that carries legitimacy, is a function of the activity and how it is not just legally, but also socially and culturally embedded with particular structures of law and sovereignty.  The exercise of those powers in ways that are alien to the terms of the judiciary – a judicial function that is embedded within the domestic structure of constitutional law, not a writ that runs to the world, to start with – seems to me inevitably to shift the nature and self-perception of the judiciary itself.

Judges start out reviewing national security decisions; they are gradually drawn in, as one speculative possibility, to police and enforce some rights concepts, until a bunch of Americans get blown up; and eventually the judges see themselves as being the political actors who make the decisions about the tradeoffs between security and liberty.  The judges that result from that process will not be the same, in their self-perception or legitimacy, as the judges that preceded it.

These are risks, not certainties.  But whether in the national security area or the financial crisis area – I draw here on some of Eric Posner’s comments at the Stanford conference on comparisons between the two – one must take appropriate account of the dynamic social nature of the process by which one assigns activities to actors that are attractive because they have discretionary authority and the legitimacy to exercise it.  The exercise of that authority changes with its exercise in new venues – and in ways that one might not anticipate or particularly want.

• a genuinely economic connection between very poor people and the capital markets, or instead
• a kind of “faux-market” in which the tools of the market were deployed as a form of artificially sustained discipline over the efficient use of resource, but nonetheless massively subsidized and, in that sense, never genuinely part of the global capital markets but instead always some sort of philanthropy.

I, like everyone else I have known in this field, have wanted to see some of the first, some of the second and, most crucially, some kind of “venture philanthropy” merger of the two that would somehow combine:

• the discipline of genuine capital markets to induce efficient use of capital to promote geniune economic growth;
• access to much larger pools of capital than are available to government aidagencies or NGOs, through the commercial capital markets;
• subsidies or guarantees to facilitate the entry of for-profit entities into the sector, in order to help them gain experience with loan-making, monitoring, default, and other costs of microfinance, and to overcome the problem of microfinance’s problematic diseconomies of scale compared to other commercial lending;
• the many social benefits of microfinance for both very poor people and not-so-poor but still poor people as separate groups; and above all,
• scalability.

So, back in the 1990s, I proposed internally to the Open Society Institute structures of credit guarantee facilities that would allow a consortium of philanthropic and government aid agencies to offer part-guarantees to banking institutions seeking to enter the sector, with the aim of doing all the above good things.  At the time – and in most situations in which I’ve inquired about this since, with the very particular exception of India – the response from the microfinance organizations was, well, that’s nice – but as a matter of fact, at this point we don’t suffer from a general lack of capital.  We can get capital at a zero or negative capital cost in the form of interest free loans from governments or straight out donations.  We don’t need to tap the capital markets, even in a subsidized form at this point, thanks very much.  Maybe someday; not now.

The reasons why this is so are important.  The microfinance providers with whom I was speaking were generally in the business of microfinance for poor people in which the transaction costs were clearly extraordinarily high for the size of the loan and possible rate of return, if one took into account all the monitoring and active involvement with the borrowers, etc., etc.  And that was leaving aside completely the transaction costs of the foreign donors and any other upstead costs; it was just the narrow cost of a local NGO engaging in microfinance loans.  Everyone likes to tout – or anyway did like to tout – the fantastic repayment rates of these microloans as evidence of client creditworthiness .  But within the sector, practitioners have always been very clear that this is on account of large investments at the front end of monitoring and reliance upon the heavy hand of social stigma and joint and several liability (as a substitute for material collateral) of other members of a “lending circle” as disciplinary mechanisms to ensure repayment.

This is nothing new; microfinance practitioners, although sometimes evangelical in their zeal for it as a development tool, have a pretty decently practical streak, and recognize that this is a subsidized – heavily subsidized – activity when it comes to most clients.  It is another instance of the problem that much of development, as William Easterly tirelessly points out and Jeffrey Sachs seems gradually to be acknowledging, is not a scalable activity.  It takes place at the capillaries, and the blockages are not the mass flows of capital – it is what happens in the “last mile.”  Talking with a finance academic who has decided to start teaching in this area – he remarked somewhat ruefully, I can’t get my students interested in this because the whole point of finance is scalability.  But there are many extraordinarily bright and experienced finance experts, people who perhaps made some money on Wall Street and decided to do something more personally satisfying in the last fifteen years, who have been bringing an immense amount of sophistication to the problem of applying finance to development.  Parts of it have worked, and parts of it are showing the problems, which is a somewhat understated way of stating the current banking for the poor crisis in India.

The grail of transforming at least part of the sector into something that is genuinely economically sustaining, in the sense of covering its costs, and being able to scale up to the point that tapping the commercial markets for capital, has never gone away.  The attraction is greatest in India – second would perhaps be South Africa – places with many very poor people, many pretty poor people, many poor people, but globally connected, globally sophisticated, utterly first world banking sectors.

India, particularly, because the size of the internal market – in this as in many other things – but also an underdeveloped and underserved one, with takeoff underway in so many other sectors, has reasons to be attracted to this model.  Economic takeoff is going to require banking models that can reach to poor people in a commercial way; it’s not precisely microfinance, and not microfinance in the “faux-market” development sense I suggested earlier.  It is the search for a genuinely commercial product of banking for the poor that provides capital and banking services – but which manages to cover costs and return a profit.  NGO development programs cannot possibly serve the needs of all those people at that level; their specialization is with a different population of very poor people.

For all these reasons and more, I have been supportive of the efforts to try and commercialize banking for poor people, in India and elsewhere.  I’ve supported rich philanthropists putting money into these businesses in an effort to try and meld the doing good and doing well.  However, the melt-down underway in India of the current model certainly gives me pause, and the belief that a fundamental rethink of the intersection of doing good and doing well is in order.  The New York Times and the Economist each have good stories this week on the crisis in India for a company that went public in India as a microfinance lender.

It’s an economic, political, and social mess in India.  Yet, although it will indeed set back the commercialization of banking for the poor for quite a while, I am persuaded that it is not a bad thing to have to sit down and re-consider the premises of venture philanthropy and combined social-profit motivations.  I say this as someone who if, for example, the Open Society Institute or some philanthropist had invited to get involved in advising things, would have leaped in – I am confident I would have led down exactly this path.  I plead no special powers to have seen ahead.

However, with the benefit of hindsight, a couple of things are becoming clear.  The banking for the poor model has important similarities to the US subprime crisis.  Particular regions of India were deluged with capital that came cheap, in part because of the subsidies for it both implicit and explicit. Lending standards were relaxed, in part because the lenders were seeking to overcome the enormous hurdle of diseconomies of scale in tiny loans – the monitoring and loan-making costs for tiny loans.  But let’s add one important difference.  So far, microcredit – crucially and more exactly, within the analytic terminology of this post, “banking for poor people” – has not yet been securitized directly, nor has it had credit derivatives built on top of it.  As someone who has been occasionally involved trying to dream up upstream financing structures that could do securitizations and derivatives in this sector, I just would like to say that I’m glad that up to this point, the sector has not yet been leveraged up in those ways.  I’m not opposed in principle to the idea that “prudent” leverage could draw more capital efficiently into the sector; I just don’t think we have any way at this point of figuring out short of meltdown what that level is.  This should, of course, sound familiar.

The problems in India are problems of an excess of capital; poor incentives among the lenders (volume not quality, for example); and a failure to be realistic about the rates of return actually achievable by poor people even when they have availability to capital; etc., etc.  But they are still mostly at the level of the limits of poor borrowers; or, again, more precisely, what happens when poor borrowers meet global capital, in the form of expected returns that can’t really be expected (i.e., opportunity cost for global capital).  That is half of it – if you’re going to attract real global capital, you have to somehow manage to pay global capital rates and that requires economic activities that produce at least that net rate of return.

But, crucially, the other half that drives this sector is apparently opposite, but actually helps crucially swell the bubble, ratchets it up, because it is the nip that draws the cat of capital out of some better return elsewhere and into this particular place, so producing a bubble.  That other half consists of rich people, rich philanthropists, for whom the amounts are simply too tiny to worry about, not really.  It helps lead the herd of capital to indisciplined lending – not the only thing, of course, but an important component, and important component in the lack of clarity that surrounds rational choice in the sector.

But it also arises from some of the most celebrated new lending models that take advantage of the “retailization” of every encounter globally via the internet; one can exchange illegal child porn, or play chess, or make microloans all the way around the world.  The model, growing in popularity, for direct person to person lending, individual rich-worlder to individual poor-worlder, is great in one way – but let’s ask ourselves, is it such a good idea to have one-to-one lending on this basis?  Should we maybe ask ourselves why in the developed world, we use intermediaries and banks.  Sure, one answer is that a huge amount of informal lending takes place through friends and family, not intermediaries, and in a sense this model replicates that.  But, well, it doesn’t, because as we all know by now, the internet creates internet friends and family, not actual friends and family.  The social virtues, as Adam Smith would have described them, are not precisely the same across continents and over the internet as they are with people with whom one has actual, not virtual, social intercourse.

And then there is the problem that what is little money to George Soros or to me or you is really big money to someone in the poor world.  They need the money, but its efficient use requires that we take it seriously and that they take it seriously.  We don’t take it seriously.  How could we?  And yet the consequences of us not taking it seriously are an unsustainable bubble, asset inflation in already poor zones, many other bad things.  We just log off and go back to our real lives, but the effects can be – are – very real.

This is what makes The Onion so hilariously right, as it nearly always is – the ludicrousness of anyone in the first world pretending that this “lending” is anything other than “donating”:

Representatives from One World Finance, a U.S.-based microcredit provider, confirmed Monday that they had initiated foreclosure proceedings on a goat in southern India following a borrower’s repeated failure to make her $2.20 monthly loan payments. “I tried to work with Ms. [Subha] Thangam on this, but once she fell a full $6.10 behind, I had to repossess the goat,” said loan officer Michael Conrad, who stated that he was just doing his job and that it was “not [his] fault” if certain subsistence farmers were living beyond their means.

Let me be utterly clear that this is not an argument for not deploying the money; anything but.  It is needed in many places.  But the combination of easy money from the rich world that, if liberated from market discipline on the local end, can create vast problems, is one that has to be re-thought at this point, in the actual practice and alignment of incentives in this sector.  We are not willing to take the goat; but if we wish to avoid bubbles and the very real damage they cause, as well as what we somewhat too anodynely call “efficiently allocate capital,” we need to ensure that our capital goes to some entity that is willing to contemplate something close to that.  Otherwise it is not operating on the margin that matters in that society, and the results are almost certainly a bubble.  I can’t do that; you can’t do that; we need not to interact in a touchy feely way with our borrower-donee, but instead hand our money over to an intermediary that has the right incentives to find that margin.

One can pile up important similarities and differences, in other words, between India’s microfinance bursting bubble and the subprime crisis.  But let me focus on one that is perhaps less noticed.  I notice it as a similarity because it’s something that (as someone who works out in the gym in Fannie Mae’s basement in Washington DC), I have heard a lot over the past dozen years: a tendency to play a self-deceptive bait and switch between doing good and doing well.  I.e., the many conversations with Fannie Mae senior staff who, when things were going well, thought (what they thought of as) their mixed social-profit model must be great, and as things weren’t going so well, took comfort in the idea that they were doing good and this was merely a cost of doing “good” business.  Something like that seems to have been present here – which hardly surprises me because I confess to having been tempted to it many times, working in or advising organizations with similarly mixed motives.

The invitation to self-deception is high, in other words.  Bertolt Brecht wrote a play – famous in its day, and one of his writings that deserves to  live on – The Good Person of Szechuan, in which a young woman of tender and generous heart inherits a tiny shop, but discovers that she cannot keep it afloat because she cannot say no to all the need around her.  So she goes on a journey and then her cousin comes to run the shop – ruthlessly and with an iron hand to make it profitable again.  And so it goes several times round.  Brecht thought of this as a condemnation of capitalism; it is perhaps rather more instructive of the virtues of not mixing motives.  I remain as committed to microfinance, as a development tool for the very poor in “faux markets,” on the one hand; and to banking for poor people as a genuinely commercial activity, on the other, subsidized in various ways.  But I do think it is time for some deep reconceptualization of the latter, particularly, and its model of capital and its social uses.

ps.  There is a vast literature, much of it excellent, on the theory and practice of microfinance.  But if you’re interested in further academic reading on this particular topic, the “upstream” funding issues, let me recommend two recent law articles.  The first is by Kevin Davis and my American University colleague Anna Gelpern.  The second is by my co-author on financial regulation, Duke University’s Steven L. Schwarcz.  My own essay on this topic, as mentioned above, is here.  And, okay, let’s acknowledge, as usual, The Onion got there first.  (HT: Insta commenter.)

Although ordinarily a company in the midst of major restructuring would have limits on its ability to use the carryforwards – and ordinarily the Treasury’s 61% stake would trigger such limitations – the IRS has ruled that companies receiving TARP bailout funds will not be subject to the restructuring limits.  (Someone can correct me, since is from memory (one of my first assignments in practice back when I started as a tax lawyer was on this very question, but I have long since dropped out of corporate tax), but I believe this is a classic section 382 problem (corrected per comment).)  The WSJ story puts the argument and counter-argument over the ruling this way:

But the federal government, in a little-noticed ruling last year, decided that companies that received U.S. bailout money under the Troubled Asset Relief Program won’t fall under that rule.

“The Internal Revenue Service has decided that the government’s involvement with these companies, both its acquisitions plus its disposals of their stock, means they should be exempt” from the rule, said Robert Willens, a New York tax consultant who advises investment banks and hedge funds.

The government’s rationale, said people familiar with the situation, is that the profit-shielding tax credit makes the bailed-out companies more attractive to investors, and that the value of the benefit is greater than the lost tax payments, especially since the tax payments would not exist if the companies fail.

In terms of the “internal” question as between GM and taxpayers, one takes the point that this can be seen as saving money for the taxpayer, or at least simply moving the losses from one pocket to another.   But even granting that, in another way it’s part of the problem.  The tax losses were generated under circumstances in which the losses and associated tax attributes, good and bad and with the tax code limitations as understood then, were about a company in which it was on one side and the Treasury as a revenue collection machine on the other.  All of a sudden, the US government has a very different interest in the company, no longer at arms length, and so now we simply see it as a shift from the taxpayer’s right to left pockets, net position unchanged.  That is true at this moment; it is not true of the situation seen over time.

But probably the biggest question the ruling raises is not about the “internal” question for GM and its USG owner, it is about its relative position to its competitors.  Even if this is just shifting from one pocket to another now that the owner is the USG, it is not merely that for GM’s competitors, who have to cope with a company that, relative to them, now has in effect “found” money.  Which, as the panelists at Stanford pointed out last week, is a real issue for the government as privileged competitor in the marketplace.  Just saying that it doesn’t matter as between government and company is not the whole story; it is also how a change in otherwise long-standing rules changes the relative positions of competitors in the marketplace.

With litigation costs rising, many plaintiffs and their lawyers do not have the money to hire expensive experts or pay for years of trial preparation. To fill this need,specialized litigation lenders are stepping in to bankroll lawsuits — often providing millions of dollars at very high interest rates because conventional banks typically do not offer such loans.

Richard Epstein, Anthony Sebok, Paul Rubin, Laurel Terry, and Susan Lorde Martin take part.

My overall take is that this creates yet another system of side bet financing, in which there are the typical problems of not having an insurable interest.  The counterargument is that the liquidity provided allows for more socially efficient litigation to take place; the response is that a liquid but also disconnected system of derivatives creates downstream bad incentives.  One does not have to reach to the financial crisis to find examples; the tobacco settlements – pathbreaking achievements in their way in structured finance – solve some problems but create some new ones.

The casualty insurance is designed to provide financial assistance in the form of cash to cover the costs of a divorce, such as legal proceedings or setting up a new apartment or house. It is sold in “units of protection.” Each unit costs $15.99 per month and provides $1,250 in coverage. So, if you bought 10 units, your initial coverage would be $12,500 and you’d be paying $15.99 per month for each of those units. In addition, every year, the company adds $250 in coverage for each unit.

Then, if you get divorced and your policy has matured (see below for the maturation rules), you would send WedLock proof of your divorce. In return, you’d receive a lump sum of cash equivalent to the amount of coverage you had purchased.

There are a couple of classic insurance questions explored in the NYT article.  One is how to prevent people who know they are going to get divorced from signing up; the key element is a maturation clause (a little bit like suicide riders in life insurance policies) that requires 48 months (reducible to 36 if you buy an additional rider) before the policy will pay off.  A second is how the company sets its rates – it does so based around the factors summarized,  more or less, in its “divorce probability calculator,” for which it claims a 13% margin of error (curiously, I thought, it does not ask how many years a married person has already been married, but maybe I err in thinking that is especially relevant).  A third is moral hazard, in the sense of inducing riskier behavior, in this case presumably lowering the inhibitions on behaviors that might lead to divorce; the approach of the policy seems to be to treat it like any other accident insurance, as an independently bad enough thing (even if monetarily compensated) so that in effect moral hazard doesn’t really operate.

The article finally explores the question of whether, at the premiums charged, it is such a good deal for a consumer couple; Schultz suggests it is not.  Will this kind of policy catch on?  My guess is not too widely, for the same reasons that prenup agreements haven’t become a standard part of marriages.  I myself would probably try to market this insurance not to couples as such, but as the “responsible” thing to take out with the children as beneficiaries – the economic effects might be exactly the same, but were I marketing it, I’d market it as the right thing to do in advance for the kids.

But the policy is a new kind of insurance, and it is hard to say what will happen.  Might such policies – this one really is modeled closely on standard casualty insurance – evolve into something quite different, something closer to a system of side-bets?  A swap market in divorce annuities, anyone?  How might we securitize marriage – or divorce?  Not to mention the problems of insurable interests and empty creditors.  (I wonder what the newly-wed Megan McArdle thinks, actually.)

(I’ll have more to say about this in another post about ‘theatre for a post-credit society’, but I will add that in some ways, this resembles a bit that very great play from the 1950s, Friedrich Durrenmatt’s somewhat forgotten The Visit of the Old Lady.  I will leave this as a cryptic teaser for the moment, however.)

Update: Folks, I have a worry that the comment thread is going to slide into various proposals for how to scam the policy, based on my summary above. I’d suggest people read the NYT article, and then if you want to propose ways to game the system, go to the company site and read the policy before proposing something. I think you’ll find that the insurance lawyers who drafted the policy are not quite as dumb as one might think based on a two graf summary above.

Another related structure of argument is that any two conditions are compatible, but not the third, as among the three of them (even without reference to a fourth condition).  And so on.  So, just on elegance of structure alone, I appreciated Professor Mankiw’s NYT column from yesterday, setting out the classic argument over incompatible policy goals in international economics, The Trilemma of International Finance:

What is the trilemma in international finance? It stems from the fact that, in most nations, economic policy makers would like to achieve these three goals:

• Make the country’s economy open to international flows of capital. Capital mobility lets a nation’s citizens diversify their holdings by investing abroad. It also encourages foreign investors to bring their resources and expertise into the country.
• Use monetary policy as a tool to help stabilize the economy. The central bank can then increase the money supply and reduce interest rates when the economy is depressed, and reduce money growth and raise interest rates when it is overheated.
• Maintain stability in the currency exchange rate. A volatile exchange rate, at times driven by speculation, can be a source of broader economic volatility. Moreover, a stable rate makes it easier for households and businesses to engage in the world economy and plan for the future.

But here’s the rub: You can’t get all three. If you pick two of these goals, the inexorable logic of economics forces you to forgo the third.

Professor Mankiw goes on to point out that the United States, China, and Europe have each chosen a different set of two in the trilemma – and part of the political and economic pressure they put on each other reflects those preferences.

But back to the form of argument – it is something that shows up sometimes in formulating arguments in the law and other places.  Other instances of recourse to this kind of argument form?  (I seem to recall that corporate law scholar, Dean Bob Clark, used something along these lines in a corporate law setting once.)

And then there is the vexed question of when one might think in terms of one, or the other, or both … which brings us to the question of the estate tax, as this Wall Street Journal article observes.  Last year, people had an incentive to stay alive, and their heirs had an incentive to keep them alive, until January 1, 2010, in order to avoid the estate tax.  It will go into reverse, however, at the end of the year:

When the Senate allowed the estate tax to lapse at the end of last year, it encouraged wealthy people near death’s door to stay alive until Jan. 1 so they could spare their heirs a 45% tax hit.  Now the situation has reversed: If Congress doesn’t change the law soon—and many experts think it won’t—the estate tax will come roaring back in 2011.  Not only will the top rate jump to 55%, but the exemption will shrink from $3.5 million per individual in 2009 to just $1 million in 2011, potentially affecting eight times as many taxpayers.  The math is ugly: On a $5 million estate, the tax consequence of dying a minute after midnight on Jan. 1, 2011 rather than two minutes earlier could be more than $2 million; on a $15 million estate, the difference could be about $8 million.

It is a question of incentives for the wealthy person, of course – but also a question for their heirs.  There is the question of perverse incentives but also, as the article discusses further, many questions of regulatory uncertainties clouding the very calculation of incentives.  Will Congress act?  At what rates and what exemptions?  Crucially, will any of it be retroactive?  Which leads to another basic principle … uncertainty raises costs.

Advisers say the estate-tax dilemma is especially awkward for heirs. “At least in December 2009, people wanted to keep their relatives alive,” says Ronald Aucutt, an estate-tax attorney with McGuire Woods in the Washington area. Now he and others are worried that heirs may be tempted to pull plugs on Dec. 31. Economists might call the taking of a life to reap a tax advantage a “perverse incentive.” District attorneys might call it homicide.

I suspect the plug-pulling problem or potential homicide problem by heirs exaggerated.  So I’d like to think, anyway.  Still, perverse incentives are perverse incentives.

Call for Papers Announcement

AALS Section on Financial Institutions and Consumer Financial Protection

Beyond Financial Reform:  Mapping Regulatory Objectives, Institutional Forms, and Accountability in the Post-Crisis Landscape

Friday, January 7, 4-5:45 pm

2011 AALS Annual Meeting

San Francisco, California

The AALS Section on Financial Institutions and Consumer Financial Services will hold a panel presentation of selected papers during the AALS 2011 Annual Meeting in San Francisco, California.

Program Summary:

Three years into the deepest financial crisis in decades, debates rage on about the core objectives of regulating finance, the relative importance of competing objectives and the relative competences of competing local, national and global regulators.  This program will assess the recent reform efforts in context, to shed light on the choices inherent in determining who gets to regulate whom, how, and for whose sake.  What, if any, tradeoffs must be made between systemic stability and growth?  … safety and soundness and consumer protection?  … risk management and innovation?  … home country, host country, and multilateral regulation?  … regulatory effectiveness and accountability?

Leading policy makers, academics and market participants have staked out positions on the merits; yet others contend that reform has been mired in false choices.  The program will address the competing claims; explore the relationships among regulation, finance, and its economic, political and social context; and try to shift the terms of theoretical and policy debates to chart the path ahead.  Of particular interest are papers that:

Engage with economic and political thought on urgent policy problems,  such as macroprudential and countercyclical regulation;

• Address the challenges of compliance, regulatory arbitrage, and regulatory capture;
• Contribute to the debate about the institutional structure of regulation and the competing bases for allocation of regulatory authority; and
• Explore insights for financial regulation from other law disciplines, including bankruptcy, international law, and administrative law, as well as institutional and behavioral fields outside the law.

Call for Papers:

Law teachers and other scholars are invited to submit a manuscript or précis on any aspect of the foregoing topic.  Junior faculty members are particularly encouraged to submit.  A review committee consisting of Section officers will select one or more papers or proposals and will invite the author(s) of each selected submission to make a presentation at the program panel.  A précis should be comprehensive enough to allow the review committee to evaluate the likely content and quality of the proposed paper; however, complete drafts will receive preference in the selection process.  Please send submissions to the Program Chair–Anna Gelpern, American University Washington College of Law, agelpern@wcl.american.edu–no later than August 1, 2010. Please forward this Call for Papers to anyone who might be interested.

Eligibility:

Faculty members of AALS member and fee-paid law schools are eligible to submit papers for this panel presentation. Foreign, visiting and adjunct faculty members, graduate students, and fellows are not eligible to submit for this panel presentation; however, any such submissions may be considered for other parts of the Section program at the Annual Meeting.

Registration Fee and Expenses:

Call for Paper participants will be responsible for paying their annual meeting registration fee and travel expenses.

How will papers be reviewed?

Papers will be selected after review by members of the Executive Committee of the Section.

Deadline date for submission:

August 1, 2010

Contact for submission and inquiries:

Anna Gelpern, American University Washington College of Law,

agelpern at wcl dot american dot edu

Authors of accepted papers will be notified in September 2010.

The government’s team, largely staffed by investment bankers, pushed the limits of its statutory authority to authorize an ad hoc series of deals designed to mitigate that crisis. It then decided to seek comprehensive legislation that, as it turned out, paved the way for more deals. The result has not been particularly coherent, but it has married transactional practice to administrative law. In fact, we think that regulation by deal provides an organizing principle, albeit a loose one, to the government’s response to the financial crisis. Dealmakers use contract to avoid some legal constraints, and often prefer to focus on arms-length negotiation, rather than regulatory authorization, as the source of legitimacy for their actions, though the law does provide a structure to their deals. They also do not always take the long view or place value on consistency, instead preferring to complete the latest deal at hand and move to the next transaction.

The marriage of “transactional practice” to “administrative law” – yes; Davidoff and Zaring’s description of it was shrewd in 2008 and it remains a shrewd way to characterize it now.  My question today was whether the embrace of discretionary authority in the Dodd-Frank bill effectively enshrined this statutory authority, with further questions about the effects on future moral hazard.  Professor Zaring has been kind enough to email me something to post.  David’s comment emphasizes not so much the question of a return to regulation by deal as the question of whether anything in the financial reform bill replaces it, e.g., through the new resolution authority.  To which his comment is (and my thanks to David for weighing in with this; you can read more of David’s comments at The Conglomerate, where he is much more sanguine that I about the overall bill):

Have we replaced regulation by deal?  The answer is probably not – because governments have been bailing out banks, often by deal, so many times over the course of the twentieth century that one would have to conclude that it is a very hard habit to break.  And I think that is an implicit part of the message of Kenneth Rogoff’s and Carmen Reinhardt’s This Time Is Different, which goes even deeper into that not-so-enviable history.

The way that Congress hopes to end the emergency dealmaking lies in the new grant of resolution authority, summarized here, which would continue to try to force the government to swing into action before desperation sets in, and extend the ability to seize and bankrupt insolvent institutions to financial holding companies, as well as to banks and thrifts (thereby reaching the Lehmans – an investment, rather than FDIC insured bank – and AIGs – an insurer – of the future).  The superquick bankruptcies would be paid for by an assessment on large banks.  It’s an important grant of authority, but will it be exercised in a pinch?  The banking regulators have had a hard time pulling the trigger on resolution authority – hence the dealmaking that ensues when times get really bad.  And, of course, the fact that the government had the power to “resolve” Fannie Mae and Freddie Mac (which it did) has not prevented either precipitous action or a big bailout.

So I’m not sure that the bill ends regulation by deal, but that is very hard to do.  And the bill will probably change the way that big banks operate, depending on the way it is enforced by the regulators, and not in altogether bad ways.

The reference to This Time Is Different is apt – it makes for (what would be the right adjective?) rueful reading late at night.  As I say, I am much less sanguine that David about this bill (see his Conglomerate post linked above); my view is approximately that of Nicole “After the Fall” Gelinas, in a quick summary for a popular audience in the New York Post today.  But I also think David is quite right about resolution authority and regulation by deal, whether before this bill or after it.  And thanks to him for the comment.

Update:  I’m happy to see that the WSJ today has more or less the same view that I’ve put out here:

The Treasury, which bailed out institutions willy-nilly without consistent rules, will now lead the Financial Stability Oversight Council that will have the arbitrary power to define which financial companies pose a “systemic risk” and which can be shut down without recourse to bankruptcy. Willy-nilly will now be the law.

I have spent a lot of the weekend reading summaries – I grant, I have not yet read the text of more than a couple of bits and pieces in the derivatives materials – of the financial regulation reform bill.  (Here is a pretty good summary from the front page of the New York Times, Saturday, June 26, 2010, by Edward Wyatt and David M. Herszenhorn.  But if you are looking for a good graphic summary of the highlights, see this graphic, “The Hope and the Worry,” that accompanies the article at page A12.)

With regard to the bill overall, well, I share the concerns raised by the editors of the Wall Street Journal and many others.  Far from eliminating too big to fail, or too systemically connected to fail, etc., the bill instead enshrines it and all the moral hazard accompanying it.  Much of the important systemic risk stuff is left in the discretionary authority of the Fed, however.  This leads me to a particular question about it.

In a certain way, this seems like a return to the phenomenon that Steven Davidoff and David Zaring identified in an article early on in the crisis – the so-called crisis response of “regulation by deal.”  Meaning by that, regulatory actions taken on a deal by deal, firm by firm basis, running through, of course, Bear, Fannie-Freddie, and so on.  Does this new discretionary authority amount to a return to the policy of regulation by deal?  A certain amount of ‘regulation by deal’ seemed justified at the moment of crisis.  But very soon into the process of regulation by deal, everyone had to consider its limitations.

What was it, from a downside view?  There was already a toxic combination of liabilities in existence – triple whammy, simultaneously massive; yet widely diffused throughout the financial system; and yet also interconnected with one another so that one failure might trigger another in unforeseen directions – based around the assumption that in any moment of crisis, they would be put to the Fed. That is, lingering moral hazard and its mis-leveraged fruits, on the one hand.  And yet completely discretionary behavior by governmental authorities as to how they would respond to crisis in any particular firm  at that particular moment, on the other.  Presumably the freedom to respond to Bear but not to Lehman would choke off the moral hazard.  The problem was, given that the liabilities and the leverage that the moral hazard had permitted had already created rafts of really-existing securities with really-existing obligations, things could not be stuffed back into Pandora’s box simply by a policy that eliminated (supposedly) the moral hazard.

Even if the regulation by deal policy was the right way to re-center the market players around risk, that policy would have to act into the future, not the past.  The result was that, at least for purposes of addressing the crisis as it was then unfolding, it merely increased uncertainties without addressing the already-ripened fruits of moral hazard.  (I’m sure if I worked at it, I could come up with a One Ring LOTR metaphor here.  But I will refrain.)  Regulation by deal could not address the moral hazard, because the externalities comprising it had been created by a vast number of deals over years; suddenly putting back in the “threat” of not getting bailed out did not make any of that go away.  At the moment of crisis, it merely increased the uncertainty.  If you were a firm, you didn’t know whether or not you would get bailed out – but since you could not really unwind all the moral hazard assuming risks all at once, in the moment of crisis, there was no “compliance” behavior that could respond to the supposed incentive.  The only result would be the same risk as before since the relevant securities had already been created – and a new dollop of uncertainty.

My question is, does the discretion now handed off to the Fed return us to “regulation by deal”?  And is this a good idea or a bad idea?  After all, in favor of it is that if it truly resolved the moral hazard problem by introducing genuine strategic uncertainty as to the Fed’s actions for any particular firm, then if this is supposed to be regulation for the future, maybe it is a good idea.    Against it?  Well, to start with, the markets would have to believe it – and believe it in the context of everything else that is in the bill.  I don’t believe it.  In fact, I think the bill should have been titled, The Dodd-Frank Put.  I think it’s a bad idea.  But do you?

(I leave aside, for now, certain public choice consequences that seem to me highly problematic with regard to the Fed role.  I also leave aside the topic in this that I follow most closely, the details of derivatives.)

If David Zaring (David blogs at The Conglomerate, but I don’t see anything from him on the new bill as yet) has any views on this, I would be delighted to post them here as a guest post.

Years ago I decided my inner geek comparative advantage was in robotics, but I read this essay with particular attention to its discussion of complexity of systems, and just how hard it is to get a handle on cyber systems, and their diffuse, distributed natures:

Many factors make computer systems vulnerable, but the most fundamental factor is their extraordinary complexity. Most computers connected to the Internet are general-purpose machines designed to perform multiple tasks. The operating-system software that manages these tasks–as well as the computer’s relationship to the user–typically has tens of millions, and sometimes more than one hundred million, lines of operating instructions, or code. It is practically impossible to identify and to analyze all the different ways these lines of code can interact or might fail to operate as expected. And when the operating-system software interfaces with computer processors, various software applications, Web browsers, and the endless and endlessly complex pieces of hardware and software that constitute the computer and telecommunications networks that make up the Internet, the potential for unforeseen mistakes or failures becomes unfathomably large.

The complexity of computer systems often leads to accidental mistakes or failures. We have all suffered computer crashes, and sometimes these crashes cause serious problems. Last year the Internet in Germany and Sweden went down for several hours due to errors in the domain name system that identifies computers on the Internet. In January of this year, a software problem in the Pentagon’s global positioning system network prevented the Air Force from locking onto satellite signals on which they depend for many tasks. The accident on the Washington Metro last summer, which killed nine people and injured dozens, was probably caused by a malfunction in the computer system that controls train movements. Three years ago, six stealth F-22 Raptor jets on their maiden flights were barely able to return to base when their onboard computers crashed.

The same complexity that leads to such malfunctions also creates vulnerabilities that human agents can use to make computer systems operate in unintended ways. Such cyber threats come in two forms. A cyber attack is an act that alters, degrades, or destroys adversary computer systems or the information in or transiting through those systems. Cyber attacks are disruptive activities. Examples include the manipulation of a computer system to take over an electricity grid, or to block military communications, or to scramble or erase banking data. Cyber exploitations, by contrast, involve no disruption, but merely monitoring and related espionage on computer systems, as well as the copying of data that is on those systems. Examples include the theft of credit card information, trade secrets, health records, or weapons software, and the interception of vital business, military, and intelligence communications.

This drew my attention in part because of my interest in complexity and complex systems interacting one another in another part of my work – finance and financial regulation.  Duke’s Steve Schwarcz and I are doing a book on financial regulation reform, and our approach – in a field currently getting saturated with books on this very topic – is to offer pragmatic, basic heuristics, rules of thumb, really, for how financial regulation needs to be designed.  Not some super deep conceptualization, but something much more practical.

The same pragmatic assessment applies to diagnosing What Went Wrong, so to speak, in financial regulation.  We have settled on the three homely, but still useful, categories of complexity, complacence, and conflicts (cupidity we take for granted).  They’re useful because they’re homely.  Complexity hides conflicts that undermine basic duties of loyalty, and breeds complacency that undermines basic duties of care, and they feed back into the development of more complexity.  They stoke each other.

Professor Schwarcz has a Washington University Law Review paper on the issue of regulating complexity in finance and financial regulation, from which we are drawing for the book.  I recommend it, partly for those interested in financial regulation issues and complexity – but I also recommend it as a way of thinking comparatively about complexity in other settings that cross-weave technological and legal-regulatory divides.

In the case of sovereign states, the analogy is apt, but not entirely so. Sovereign states, even when they default on their obligations, do not simply disappear “into” (much less “in”) bankruptcy the way a private firm would, unless the firm had the deus ex machina of a government bailout.  States don’t just go away, their assets sold off and distributed out to the creditors.  The question of solvency or insolvency – the urgent information gap that has driven much of the recent Greek debt crisis – is not so much a question of solvency today, as whether a state can muster the political will to be solvent into the future.

Questions of political will across a long time horizon are by their nature deeply uncertain, not least from an investor’s point of view.  So it seems likely that in the absence of a flat out guarantee from a trusted party – the EU or its leading members – liquidity issues (including not just risk premiums, but much volatility in debt pricing, reflecting genuine uncertainties) will trouble Greece, and other shaky euro economies.  The special sovereign uncertainties arise as investors seek to bridge an information gap that is fundamentally about the special solvency issue for a sovereign state – long term political will.  Can a trillion-dollar euro fund allay the uncertainties, not just today, but over the required time horizon?

(Whatever the answer to that question, it seems to me that Professor Anna Gelpern, whose Roubini blog post I earlier referenced, is right in saying that Greece does not have much reason to seek a restructuring at this point in time.)

The so-called European stabilisation mechanism will consist of two parts with separate legal bases.

The €60bn extension of the EU’s existing balance of payments facility – used to help Hungary, Latvia and Romania – to members of the eurozone will be based on Article 122.2 of the EU treaty which allows for support for governments during “exceptional circumstances”. It thus circumvents the eurozone’s no-bailout principle.

The €440bn loan guarantee mechanism will be organised on an intergovernmental basis between the 16 eurozone member states.

Why the intergovernmental structure for the overwhelming bulk of it?  For political and legal reasons – first, to deal with German constitutional legal concerns and, second, to deal with British political concerns that it could be dragged into indirect liability if the fund were handled through Brussels institutions.  The governments will provide credit guarantees; the intergovernmental SPV will use the guarantees to raise money on the capital markets.  The 60 bn euro piece from the EU directly will come in the form of debt collateralized by the EU’s own budget.

Leading economists and editorialists say Greece will restructure its debt (here, here, here, here and here are just a few examples).  Many say so because they see so much in common between the spiraling European crisis and past crises in the emerging markets.  The analogy has merit, and until recently, I too subscribed to it.  Now I am not so sure.  This is because the benefits of restructuring now are oddly remote, because Greece has the legal leverage to extract a deep debt haircut if and when it can maximize its benefits, because the EU needs time to get its act together and seems willing to pay for it—and because, as a descriptive matter, the global political commitment behind the no-restructuring option is without precedent.  And sovereign debt is nothing but political commitment.

The post goes on to offer six reasons why restructuring is not likely for now.  Trenchant analysis, highly recommended.

MY favorite proposal is to require banks, and perhaps a broad class of financial institutions, to sell contingent debt that can be converted to equity when a regulator deems that these institutions have insufficient capital. This debt would be a form of preplanned recapitalization in the event of a financial crisis, and the infusion of capital would be with private, rather than taxpayer, funds. Think of it as crisis insurance.

Bankers may balk at this proposal, because it would raise the cost of doing business. The buyers of these bonds would need to be compensated for providing this insurance.

But this contingent debt would also give bankers an incentive to limit risk by, say, reducing leverage. The safer these financial institutions are, the less likely the contingency would be triggered and the less they would need to pay for this debt.

I agree it is a good idea.  But I’d like to ask what this would look like from the finance lawyer’s drafting point of view.  Suppose you proposed to do what Professor Mankiw says above.  First off, can anyone point me in the direction of any actual examples of what this is – any examples of convertible bond documents online designed to do this?  Any bond documents for this exist in real life?

Second, what would be the basic functional terms of the bond that would make this happen – what would the triggers be?  And finally, what would be the covenants and protections for, e.g., the regulator, the financial institution, and the bondholder?  What would they want to be protected against, respectively?

For that matter, is there any reason to think that while aligning some interests in controlling leverage, this proposal either creates other unintended perverse incentives, or perhaps creates other kinds of possibly unresolvable conflicts of interest between these three parties (and potentially the existing shareholders as well).  Put on your bond lawyer hats!

Democrats won the support of a senior Republican who voted in a Senate committee Wednesday for a sweeping overhaul of the market for derivatives, the complex financial instruments at the heart of the financial crisis.  The backing from Sen. Charles Grassley (R., Iowa) is the first sign of what Democrats hope will be an eventual wave of Republican support …  The move was also significant because Mr. Grassley said he favored one of the bill’s most controversial elements, a provision that could force Wall Street banks to spin off their derivatives trading desks.   The 13-8 vote in the Senate Agriculture Committee came as Senate lawmakers appeared to be inching closer to a deal on a broader remake of market rules.

The New York Times reported yesterday on negotiations over financial regulation legislation, and included this comment on derivatives regulation and Wall Street:

The derivatives bill, which is expected to be folded into the sweeping overhaul of the nation’s banking system, would also require most derivatives trades to be routed through a third party, known as a clearing agent. That would provide each of the parties a guarantee that they would be paid if the other party defaulted or went out of business. The bill would also require most derivatives to be traded on an open exchange.

Currently, the only way to trade many derivatives is to call up various dealers and ask for the price at which they are willing to buy or sell. The securities dealer profits from the difference between the prices at which it buys from one party and sells to another. Investors rarely, if ever, see details on the other side of the trade. Wall Street has signaled that it can live with a clearinghouse approach, but it is strongly opposed to exchange trading of derivatives, which would introduce price competition and lower the profits.

I think it’s fair to quote those two grafs from the lengthy article, which covers many aspects of the bill negotiations.  Here is my question – and it’s a genuine question, I’m not sure exactly what to think.

I had more or less assumed that Wall Street would be bothered more by a clearinghouse than an exchange, if it were one or the other and not both.  Why?  I assumed Wall Street would be concerned that a clearinghouse serving as a centralized counterparty would be motivated to contain its risk, by limiting margin and generally limiting leverage on the contracts for which it ultimately was responsible to clear.  The exchange seemed much weaker as a regulatory device because it would not have the ability, or at least the same incentives, to limit margin.  The exchange would help matters by making public the prices and counterparties, but not act to clear and, so, have to think about its own risk.  (If you had both, however, you would have the advantages of an entity motivated to limit risk and with public information on prices by which to help the determination of regulatory margin.  But we’re assuming here it is one or the other, although I myself strongly would like to see both.)

So I was surprised to read this passage and see my assumptions turned on their head.  And maybe I should never have been surprised, and this ordering preference should have been obvious.  But it did surprise me.  Which then leads me to the further thought, what is Wall Street’s assumption on the NYT’s description of its ordering preferences?  Wall Street prefers a clearinghouse that takes central counterparty risk but which should then address attendant risks?  Why?  Is it because of an assumption that – in a market that does not publicly post prices for everyone to see – if leverage gets out of control, the central clearinghouse will serve as the clearer of last resort?

In other words, does a clearinghouse without a public posting of exchange prices increase or decrease the likelihood that the central clearinghouse (in practical effect backed by the Federal government, which blessed the system through legislation after all) run the serious risk of serving as the next Wall Street bailout mechanism?  The New Fed-Market Put Option?

I don’t know the answer to this; this reporting surprised me, so I put the proposition to you.  Or have I misconceived Wall Street’s motivations or misunderstood what this ordering preference is all about?  Please stay on topic here and directly address these issues.

(Update 2.  Also see Gary Gensler urging a clearinghouse in the Wall Street Journal today, and Thomas Jackson and David Skeel, also in today’s WSJ, urging that derivatives be treated like other contracts in bankruptcy as a mechanism by which failed parties could have the regular bankruptcy protection against contract enforcement and so avoid cascading risk – and financial firms would not have to put (or give up) their customized derivatives onto exchanges (i.e., make everything into a uniform plain vanilla derivative).)

One of those stories (they have all, ahem, melded together in my mind) remarked that if sustained in court, and quite possibly even if not, the fraud suit and the narrative it tells, has the possibility of significantly altering the perception of the financial crisis, or at least its relationship to complex derivatives.  Away from a (possible, anyway one I share) perception of banks that didn’t much care about the down-stream performance of their products because they would get paid up-stream anyway – a perception of a systemically driven indifference, but not necessarily fraudulent, toward knowing, deliberately constructed malfeasance, understanding pretty well that these CDOs were headed to the dust-bin of history.

Such a shift in perception might come about regardless of whether this narrative is established as factually correct or not.  Another version might be that most of Wall Street was complacent and badly incentivized, so as to not care about credit quality – whereas Goldman Sachs, being the Masters of the Universe and Smarter Than the Average Bear (Stearns -ed.), uniquely saw it coming  and, in this case at least, protected itself and even figured out how to profit, but alas through fraud.

One of the problems with trying to say much at this stage about the legal analysis is that it is so factually driven.  If the facts are as the SEC alleges, well, then, bad, bad Goldman!!  But  on these allegations, there’s not a lot of room for legal nuance, although I am happy to be corrected on that in the comments, not being a securities litigator.  So, here’s my question for the comments.  Assume that the facts are as alleged.  In that case, is there an important legal issue, or is it the application of straight securities fraud principles?  Is there an alternative, plausible reading of the facts?  And is there an alternative, plausible factual reading that creates an important legal question?

That’s with respect to the fraud case on its own.  Assume the facts as alleged by the SEC.  What would that argue as a matter of long term regulatory reform in financial markets and institutions and regulation?  Although, frankly, at this stage, I’m more interested in the comments in trying to see whether there’s an important legal issue in the case at hand, as a legal issue.  As the New York Times Room for Debate blog exchange seemed to show, at this stage the systemic lessons people seem to be drawing out of the suit against Goldman are pretty much whatever they thought before the suit against Goldman.

Alan proposes raising capital requirements and reducing leverage, but he suggests that there are limits to how much we can do so. If we reduce leverage too much, he argues, financial intermediaries will be not be sufficiently profitable to remain viable. He offers some back-of-the-envelope calculations that purport to show how much leverage the financial system needs to stay afloat.

When I read this part of the paper, my first thought was: What about the Modigliani-Miller Theorem? Recall that this famous theorem says that a firm’s value as a business enterprise is independent of how it is financed. The debt-equity ratio determines how the risky cash flow from operations is divided among creditors and owners. But it does not affect whether the firm is fundamentally viable as an on-going concern. It seems to me that, as least as first approximation, the logic of this theorem should apply to financial intermediaries as well as other types of business. If not, we need some explanation as to why.

Note that this is a different objection to imposing higher/firmer/objective/fixed minimum/what have you capital versus leverage requirements than is sometimes made – viz., that no one, least of all regulators, is in any good position to be able to determine the proper level, and that, therefore, the problem ought to be to ensure that risk falls so as to ensure that those that should care, do care.  Greenspan is suggesting, rather, that without some minimum level of leverage that might well turn out to be crisis-inducing risky, financial firms will not have a sufficient level of profitability to remain in business.  I might have misunderstood that reading the paper, so if (and only if) you have read the paper, feel free to correct me in the comments.

If my understanding of the paper is correct, I think my reaction would be … as compared to what alternative on a risk adjusted basis?  It seems to me that the problem identified here is a “gotta get up and dance” issue – if on a short term basis, all your competitors are engaged in a certain level of leverage, and are hitting certain rates of return while, in fact, taking inefficiently high risks considered over a longer run, then, sure, you might not remain in business.  If, on the other hand, leverage for all market players (at least in the taxpayer guaranteed sector) is constrained, sure, rates of return will be lower.  But if the effect, on a long term basis, is to force return to take into account risk, and properly price it for all players, then capital will flee the sector and threaten, perhaps, to put financial firms out of business only insofar as capital wants to take greater risks for greater returns in other asset classes and investment opportunities.

But of course I might have misunderstood something fundamental, particularly since Greg Mankiw zooms in on something quite different, Miller and Modigliani.  He asks what M&M would have to say about Greenspan’s argument – and maybe he is saying something similar to what I suggest above, although I have focused on short term versus longer term risk versus return:

I have a hunch as to where, from the Modigliani-Miller perspective, Alan’s calculations go awry. Alan assumes that the rate of return on equity must be at least 5 percent. But this number should be endogenous to the degree of leverage. If a bank is less levered, its equity will be safer. (It will be like a combination of today’s equity and bonds.) As a result, the required rate of return should fall.

Thus, Mankiw goes on, a less levered – indeed, wholly unlevered – bank should do just fine with a rate of return that reflects the decreased risk.  Investors who want that kind of safety as part of their portfolio will gravitate to that bank.  The problem, as I suggest above, is when risk and return in the capital market for all firms is skewed so as to favor getting up to dance in the short term.  But then Mankiw raises the general question of the applicability of M&M to this case:

To put the point most broadly: The Modigliani-Miller theorem says leverage and capital structure are irrelevant, while undoubtedly many bankers would claim they are central to the process of financial intermediation. A compelling question on the research agenda is to figure out who is right, and why.

Actually, this seems to me to put M&M in a highly specific context – rather than being the classic question, does capital structure matter to the value of the firm? – this question is quite exact – do leverage and capital structure matter to the process of financial intermediation?  If the question is financial intermediation alone – so-called narrow banking – I’d hazard that it still matters.  Mankiw proposes a thought experiment with a wholly unleveraged bank – could it supply financial intermediation?  Answer, presumably yes, at least if the playing field for capital is level, so that return reflects risk.

But isn’t the more difficult question, if one is following the symmetry of M&M, to ask, can a bank perform the functions of financial intermediation with something close to total leverage?  Wouldn’t M&M suggest it should be able to do that as well?  And hasn’t the meltdown suggested that, for some reason, it doesn’t work that way – rather than being symmetric as pure M&M in a pure world would suggest, in our world, firms, leverage and assets are asymmetric?  To be sure, the financial intermediation part might have worked just fine, which, true, confirms Mankiw’s point.  But the firm itself seems not to have worked – meaning, those arguing that in our world, capital structure and degree of leverage matter, and even matter with respect to a firm conducting financial intermediation, given that if the firm goes kaput on account of overleverage, the intermediation collapses with it?  Which is another way to say, Mankiw suggests through the unlevered thought experiment that financial intermediation can be “unbundled” from the rest of a financial services conglomerate, and that seems right.  But it seems equally right – and not consistent with “pure” M&M in a “pure” world – that you can’t successfully “bundle” them, at least not to the leveraged limit.

If that is so, how does one account for it within the broad framework of M&M?  With some (lots of) trepidation, let me sound very much like a commercial lawyer here and note something that is always uppermost in my mind when I teach M&M.  It is that what is called “debt” for these purposes does not look entirely and purely like debt, at least not when one looks at the actual contractual pieces of paper.  Mankiw gives a concise explanation of M&M when he says:

The debt-equity ratio determines how the risky cash flow from operations is divided among creditors and owners. But it does not affect whether the firm is fundamentally viable as an on-going concern.

“On-going concern”?  When that term is raised, at least to the lawyers reading the contracts,  I think (and think we lawyers think), what is called “debt” involves, at the granular level, a huge number of financial options built into and around the instruments.  It might be better thought of (and valued at the risk margins) as bundles of options ultimately enforceable, or not, in various ways through bankruptcy.  Mostly they are exercisable at the option of the creditor, but sometime they are implicit rights exercisable by a borrower-owner that has been, e.g., insufficiently constrained by lending covenants, including the ability to leverage up in direct and indirect ways.  Some of them are really exercisable in the discretion of the bankruptcy courts or creditors’ committees.

Collateral and margin calls, the spill on effects of mark to market rules, lots of things have the consequence of meaning that, whether the business is viable as an on-going firm, really amounts to the question (in reverse, so to speak) of whether the firm can be pushed into bankruptcy or insolvency (or close enough) by economic actors holding explicit but embedded, or implicit, options within credit instruments.  Debt is an extraordinarily lumpy bunch of contractual thingies seen at the granular level, especially if you have to take into account what other debt instruments outstanding mean for this debt instrument.  If the question of M&M is at the margins, and in particular a question specifically of the on-going enterprise – not just its “value” but the fundamental solvency-insolvency-bankruptcy law question of its “viability,” then those implicit and embedded options presumably rise in value, but in ways that are highly contingent and uncertain.

Add to that the related observation that financial institutions tend to ramp up by asset, acquiring each new security or bunch of securities, on a semi-smooth and semi-continuous curve of assets and returns and risks and leverage.  But collapse – because of the way in which the law governing insolvency, creditors’ rights, bankruptcy, and so on operate, collapse is not continuous and by asset.  Like a series of brick floors smashing into the next one below in an unsupported building in an earthquake.  House of cards, quite exactly – built card by card, collapsing as a house.  It is not simply an unwinding of its assets and leverage in the way that it flowed up the curve, but instead one (or more) institutional collapses. Rise by asset, fall by institution.

If one is operating on the margins of those risks, and if those risks are risks not of debt per se, but of options that are closely tied in but not quite visible, including sometimes the option of pushing the enterprise all at once, and not just some particular asset, over the cliff – then it seems to me that M&M implies something quite different.  The valuation will look at lot more at volatility as we get closer to the margins, for one thing, and it seems unlikely that it will look very much like what classic M&M says for debt and equity, even if M&M is the starting model, which I think it is.

Meaning:  If debt and equity are seen instead as bunches and bundles of implicit options, running sometimes in favor of the owners and sometimes in favor of the creditors, and if rise and fall are asymmetric as described above, then …  M&M seems to me to be still applicable, but to mean something quite different when it is about financing by means of multiple options rather than classic debt and equity as the only two possibilities.  And isn’t this really what bankers mean, or at least part of what they mean, when they say that leverage and capital structure are far from irrelevant?  Lying behind the owner-creditor divide are different ways, sometimes highly contingent and indeed inconsistent, of allocating control, where “control” can mean anything from operational control to the ability to push the firm itself over the edge?

But look, I feel sheepish daring to comment on Greg Mankiw and Alan Greenspan, so feel free to correct me.  It would help, however, if you have read the Greenspan paper.  I’d be particularly interested in what people with experience in bankruptcy and creditors’ rights – including our own Todd Z and others – might say if they were commenting on Mankiw.  Have I understood Mankiw and Greenspan or, for that matter, M&M all wrong at least in this context?

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.)

Regarding the insurable interest question and “speculative” trading in CDSs, here is Gensler on both speculative trading and the “empty creditor” problem (it’s a lengthy quote from the speech, which I include for completeness):

Market Manipulation

The CFTC and the SEC should have clear authority to police the over-the-counter derivatives markets for fraud, manipulation and other abuses. It is important that these markets serve to help people hedge risk as well as provide for efficient and transparent price discovery markets.

At the height of the crisis in the fall of 2008, stock prices, particularly of financial companies, were in a free fall. Some observers believe that CDS figured into that decline. They contend that, as buyers of credit default swaps had an incentive to see a company fail, they may have engaged in market activity to help undermine an underlying company’s prospects. This analysis has led some observers to suggest that credit default swap trading should be restricted or even prohibited when the protection buyer does not have an underlying interest.

Though credit default swaps have existed for only a relatively short period of time, the debate they evoke has parallels to debates as far back as 18th Century England over insurance and the role of speculators. English insurance underwriters in the 1700s often sold insurance on ships to individuals who did not own the vessels or their cargo. The practice was said to create an incentive to buy protection and then seek to destroy the insured property. It should come as no surprise that seaworthy ships began sinking. In 1746, the English Parliament enacted the Statute of George II, which recognized that “a mischievous kind of gaming or wagering” had caused “great numbers of ships, with their cargoes, [to] have . . . been fraudulently lost and destroyed.” The statute established that protection for shipping risks not supported by an interest in the underlying vessel would be “null and void to all intents and purposes.”

For a time, however, it remained legal to buy insurance on another person’s life in England. It took another 28 years and a new king, King George III, before Parliament banned insuring a life without an insurable interest.

The debate over the role of speculators in markets did not end in the 18th century. That debate continued as the CFTC’s predecessor and the SEC were set up following an earlier crisis and that debate continues on to this day. In the case of futures, Congress determined that speculators should be able to meet hedgers in a centralized marketplace. In the oil market, for example, a speculator that will neither produce nor purchase oil is able to buy or sell oil futures. But Congress did require that all such futures trading be regulated, that markets be protected against fraud and manipulation and that regulators be authorized to limit the size of the position that a speculator can take.

The Administration has recommended – and the House financial regulatory reform bill that passed in December includes – critical steps to address the use of CDS to manipulate markets or possibly commit other abuses. With regard to single-issuer CDS or narrow-based CDS, the SEC should have consistent authority over all financial instruments subject to its jurisdiction. The SEC should have the same general anti-fraud and anti-manipulation rulemaking authority with respect to credit default swaps under its jurisdiction as it has with regard to all securities and securities derivatives under its jurisdiction. In addition, the SEC should have authority to set position limits in single-issuer and narrow-based CDS markets as it now has for other single-issuer or narrow-based securities derivatives. The House bill allows the SEC to aggregate and limit positions with respect to an underlying entity across markets, including options, equity securities, debt and single-stock futures markets.

Bankruptcy

Credit default swaps also can play a significant role once a company has defaulted or gone into bankruptcy. Bondholders and creditors who have CDS protection that exceeds their actual credit exposure may thus benefit more from the underlying company’s bankruptcy than if the underlying company succeeds. These parties, sometimes called “empty creditors,” might have an incentive to force a company into default or bankruptcy. These so-called empty creditors also have different economic interests once a company defaults than other creditors who are not CDS holders.

These incentives result from the separation of economic risk from beneficial ownership. In the capital markets, assuming economic risk usually comes with some type of governance right. Shareholders place their investment at risk, which brings the right to vote and to inspect books and records. Debtholders may extend credit or buy bonds along with rights as outlined in various debt covenants and indentures, as well as having rights in bankruptcy court.

Though reform efforts to date have yet to address the bankruptcy laws, we should seriously consider modifications to address this new development in capital markets. One possible reform would be to require CDS-protected creditors of bankrupt companies to disclose their positions. Another is to specifically authorize bankruptcy judges to restrict or limit the participation of “empty creditors” in bankruptcy proceedings.

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.

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?

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).

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.

*

(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.

(Note, from a Coasean perspective, that one of the problems here is not just transaction costs, but apparently the problem that the legal rights are not fully specified.  I mean by that in part that it’s not clear (so far as I can tell, I might be wrong) how and whether there are any options for forcing Greece out of the euro, or whether it has an absolute right to stay in or stay in with consequences legally specified or not specified.  Maybe all that is somehow spelled out in various Eurozone agreements and directives, and I’ll leave the international banking lawyers to tell me, but I’ve been unable to see something that clearly specifies the legal rights involved.)

I assume there is also a problem of past debts already being denominated in euros.  And probably lots of other problems as well.  However, explain why, or why not, it would not be in principle a good idea to combine the two options above and have the Eurozone pay to have Greece withdraw.  With some kind of politically face-saving explanation about “temporary” or what have you – but still getting out?  What and how much (or at least the factors affecting such) would the solvent Eurozone have to pay, and what would be the pressures on that price – I assume the implied costs of the legal rules involved, related to default, forcing Greece out, other things.

Am I right in thinking that someone must already be far, far along the curve in thinking through such possibilities?  Can someone point me to published sources?  Or is there a reason why this idea is a non-starter?  Finally, how would you frame this as a Coasean hypothetical, limited to one paragraph and highly simplified?  Or is it somehow not suited to work as a Coase Theorem hypo?

(Update:)  Thanks to Dutch international law scholar Martinned in the comments to an earlier post, here is a summary of the relevant rules regarding ‘in’ and ‘out’ of the euro.  Two further questions:

• First, does this support the proposition that Greece won’t be bribable because staying in the euro is its best deal?
• Second, does this sufficiently specify the legal rights such that you could create a Coase Theorem hypo based around bargaining by, let’s say for simplicity, Greece and Germany?  Even if the result were, Greek default?

Martinned@prof. Anderson: Everything you need to know about countries being kicked out of the Eurozone, leaving unilaterally, etc. is in this ECB working paper from December. In a nutshell, the answer is that it can’t be done. The Treaties are written based on the assumption that all EU member states are members of the Eurozone, and that to the extent that some are not, this is temporary. The idea of going from inside the Eurozone to outside was simply never contemplated. Under the Lisbon Treaty, Greece now has the explicit right to leave the EU as a whole, but there is no way to make a country leave the EU. A country’s voting rights in the Council can be suspended for human rights infractions, and a country can be fined for sins against the stability and growth pact. Those are about the most drastic measures that can be taken.

So nobody can force anybody to do anything. Greece can’t be forced out of the Euro or the EU, and the others can’t be forced to bail Greece out. (At least not legally.) If Greece defaults, that is unfortunate, but the only consequences that would have for the other MS are economic. (i.e. Market panic and other contagion.)

(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 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.)

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 ….  ….  To put it simply, in no sense would these capital market institutions be deemed “too big to fail.” What they would be free to do is to innovate, to trade, to speculate, to manage private pools of capital — and as ordinary businesses in a capitalist economy, to fail.

I do not deal here with other key issues of structural reform. Surely, effective arrangements for clearing and settlement and other restrictions in the now enormous market for derivatives should be agreed to as part of the present reform program. So should the need for a designated agency — preferably the Federal Reserve — charged with reviewing and appraising market developments, identifying sources of weakness and recommending action to deal with the emerging problems. Those and other matters are part of the administration’s program and now under international consideration.

In this country, I believe regulation of large insurance companies operating over many states needs to be reviewed. We also face a large challenge in rebuilding an efficient, competitive private mortgage market, an area in which commercial bank participation is needed. Those are matters for another day.  What is essential now is that we work with other nations hosting large financial markets to reach a broad consensus on an outline for the needed structural reforms, certainly including those that the president has recently set out.

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.  She calls it (perhaps hopefully), “The End of Moral Hazard?”:

The administration’s new proposal has two core pieces, both of which are at least somewhat novel.  First, banks that have access to the discount window will not be able to trade for their own account.  That means no prop trading desk.  No owning hedge funds or private equity funds.  No investments of any kind to make profits for your shareholders.  Financial institutions can make profits by servicing clients, or they can make profits by investing for their own book.  But they can’t do both.

Senior administration officials I spoke to made it clear that this would not include market making activity, which the administration views as something you do for your clients.  But while that may partially reassure banks, that seems to mean that market makers–i.e. Goldman Sachs–are very definitely included …  Indeed, if they pass this thing, they should probably call it the Hey Goldman Sachs! You’re Not Going to Be So Profitable Any More Act of 2010.

The second proposal is to extend something like the caps that already prohibit banks from holding more than 10% of federally insured deposits, to other kinds of liabilities.  I asked, but got no clarity, on what exactly this means.  Are regulators going to swoop in whenever a diversified financial institution has too big a share of the total liabilities in all US debt markets?  Or are they going to intervene when a bank becomes dangerous to one particular debt market, the way Lehman turned out to be in commercial paper? ….

Now, as to the merits of the policy:  is it a good idea?  On first pass, I’m going to say tenatively yes.  The government is recognizing that banks “paying back” the funds they were given is essentially meaningless, because they’ve still got a very, very valuable implied government guarantee.  One could argue that they’ve had it since 1991 when the Federal Reserve got the power to loan money to investment banks in extremis.  But since last fall, it’s the next best thing to explicit.  That means the government needs to take steps to mitigate its own risk.

The way you do that is to decouple the key operation the government insures–the funneling of credit from those with money to those who want to borrow it–from making bets on market outcomes that can go badly wrong.  And to ensure that no institution has enough liabilities to take down the system if it fails.  That said, I’m not necessarily confident that this is going to work.  I’m not even sure that I understand how it will work at this point.

Manzi concludes his discussion with a somewhat hopeful, perhaps overly optimistic take on the politics of the situation – one that, perhaps, underestimates the power of Congress to be bought off by various special interests.  (I would assume that its preferred solution would be closer to (a) impose fairly modest but theatrical populist taxes on bank bonuses (b) not actually rein in the financial services sector save in cosmetic ways (c) preserve some kind of direct conduit for rent-seeking in the form of GSEs like Fannie and Freddie to funnel public money and take in campaign contributions and (d) continue to get financial services industry donations in large amounts.)  Concludes Manzi:

The political aspects of such reform are compelling. People are disgusted at recent bank bonuses. I’m a right-of-center libertarian businessman, and I’m disgusted by them. Make no mistake, many banking executives right now are benefiting from taxpayer subsidies. Even if they pay back the TARP money, the government has demonstrated that it will intervene to protect large banks. This can’t be paid back. And this implicit, but very real, guarantee represents an enormous transfer of economic value from taxpayers to any bank executives and investors who are willing to take advantage of it. Unsurprisingly, pretty much all of them are.

The “populist” observation that the fact of a bunch of well-connected guys each pulling down $10 million per year while suckling on the government teat constitutes almost certain evidence of self-dealing is accurate, and all the fancy finance talk in the world can’t get around it. President Obama has a clear political incentive to pursue this proposal. I assume Republicans will see that they have a clear political incentive to go along, rather than standing up for such a situation. Hopefully, this will create the political dynamic that will allow real, positive reform.

Finally, I’ll just note this WSJ article noting that Paul Volker, who long appeared to be sidelined in these discussions, while arguing strenuously for a separation along these lines, appears to have won the conceptual day in what amounts to a policy pivot for the administration.  It’s a very interesting article describing how that came about.

The policy’s evolution took months, according to congressional and administration officials. Prompted by the cajoling of former Federal Reserve Chairman Paul Volcker and other respected voices, dissenters in the administration—notably Treasury Secretary Timothy Geithner and White House economics chief Lawrence Summers—gradually dropped their opposition ….

On Thursday, Mr. Obama proposed a plan that would prevent banks that receive a federal backstop from investing their own money in financial markets—what is known as proprietary trading. He also pushed for new limits on the size and concentration of financial institutions. Both moves echo the Glass-Steagall Act, the Depression-era banking curbs that was repealed in 1999.

The proposal marked the return of Mr. Volcker to center stage in the Obama White House. The 82-year-old chairman of the president’s Economic Recovery Advisory Board consulted closely with Democrats in the House and Senate as they drafted their proposals to address “too big to fail” entities, referring to financial behemoths whose collapse might bring down the economy. Mr. Volcker spoke frequently with Mr. Obama as well.

But he faced a philosophical divide with others on the economic team ….  In talks with his financial team, Mr. Obama started letting his frustration show, asking why he was on the wrong side of the “too big to fail” debate.

White House officials said the president called a meeting of his entire economic team to press for additional proposals. But its members were at odds: Messrs. Geithner and Summers argued that proprietary trading was a problem but not a central cause of the financial crisis, according to an official familiar with the talks. Mr. Volcker saw proprietary trading as a fundamental risk.

In December, Mr. Obama decided he wanted to be on what he saw as “the right side” of the debate, according to an administration official. He asked his team to bring him specific proposals to limit the size of financial institutions and halt proprietary trading. Spurring their thinking: Goldman Sachs had sought the protection of the Federal Reserve during the financial crisis, and was now making big profits from its own trading, in part because it benefited from the explicit backing of the U.S.

It was a big step for the administration. White House economists argued that transparency and disclosure alone could shape Wall Street behavior.  But Mr. Obama was now on Mr. Volcker’s side.

Update:  It is also quite important to add here McArdle’s observation that many of the relaxations of the line between these activities were justified on the grounds that the regulations made New York less competitive as a banking and money center globally.  She correctly says that reimposition of such lines will make New York less globally competitive:

If we do choose this “something”, Americans should probably be clear that this is going to deal a major setback to New York as a world financial capital.  Many of the rules that were undone in the last two decades were got rid of because they were making it too hard for American banks to cope with foreign competition.  If we do this, America’s financial sector will shrink, and our banks will lose a lot of business to foreign firms.  That means, among other things, that we are going to lose big chunks of tax revenue, because bankers are very disproportionate contributors to federal coffers.  It also means that New York’s renaissance will probably slack off–and the people who complain about the bankers will discover how many city services those banker salaries paid for.

I believe McArdle is right.  I would add, however, that in the long run, the move to re-impose moral hazard regulation might – I hope would – increase the general stability of the US capital markets, and over the long term (it will a long time after having trained the bankers so thoroughly in externalizing their risks, I imagine) have the effect of reducing uncertainty with regards to capital markets and flows through New York.  London might well gain in the medium term, likewise other places – but they might also be significantly more unstable over the long run, and encourage a return to New York.

For that matter, McArdle’s final blog point, that the financial sector in the US had got too large anyway – well, that applies even more to London and the UK economy.  In a place like London, it might translate into much greater instability in moments of crisis.  Competitive pressures on London might turn out to mean accepting more risk and moral hazard for the sake of remaining a competitive industry that sustains much of the rest of the your national economy.  The relative size of the financial services sector in Britain arguably suggests this (I don’t have time now to provide links), at least by comparison to the vastly more diversified US economy.

How does that risk express itself, however?  Again, arguably, in Taleb distributions – it all goes swimmingly, so to speak, until you drown.  How many times, in order to remain globally competitive as a financial center, can the UK public fisc swallow the occasional disastrous meltdown?  Meanwhile, a less competitive, but also less competitively pressured, New York financial center gradually acquires a reputation for stability in the much longer term, fewer political uncertainties because the moral hazard does not exist in the first place … might work.  Of course, might not.

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?