The Volokh Conspiracy

I just finished reading Alan Greenspan’s paper for the spring Brookings economics confab, The Crisis, and then a bunch of reactions around the econo-blogosphere.  The paper is well worth reading – it’s time to get beyond the blame game and the mea culpas and mea non-culpas, in order to get to longer term regulatory reform.  Of the blog reactions, the most interesting, I thought, was Greg Mankiw, who was a respondent on the paper at Brookings:

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. Continue reading ‘Greenspan’s ‘The Crisis’ and Modigliani and Miller’ »

Government efforts to subsidize homeownership helped cause or at least exacerbate the financial crisis, and left taxpayers on the hook for hundreds of billions of dollars in liability for dubious mortgages. In this recent New York Times op ed, Yale economist Robert Shiller, a leading expert on housing markets, concedes that such subsidies have little economic justification, but argues that we need to maintain them to preserve America’s “national identity”:

For decades, the federal government has subsidized housing — particularly owner-occupied housing. This has been especially true during the continuing financial crisis, with Fannie Mae, Freddie Mac and the Federal Housing Administration propping up the housing market by issuing guarantees for investors on most new mortgages.

But what is the long-term justification for putting taxpayers on the line to subsidize homeownership? Is this nothing more than a sacred cow in American society — a political necessity because so many voters own homes and are mindful of their resale value?

In fact, there is much more to the history of subsidizing housing. While the crisis in the housing market shows that our current approach is far from perfect, there is a certain wisdom behind it, related not only to economic stimulus but also to the preservation of a sense of national identity. It’s important to remember this as we consider re-engineering our institutions as the crisis ebbs. …

But consider what will happen once the economy is again operating at full capacity. Basic economics tells us that when Americans, over all, spend more on housing, they must ultimately spend less on something else. Why should housing consumption be better than other consumption, or investments that people might choose?

This time, the best answer isn’t found in traditional economics but rather in American culture: a long-standing feeling that owning homes in healthy communities is connected to individual liberties that embody our national identity. Historically, homeownership has been associated with freedom, while renting — often in tenements or mill villages — has been linked to the oppression of a landlord.

Shiller is an outstanding scholar. But this particular argument of his seems weak. Even if Americans have traditionally believed that “owning homes in healthy communities is connected to individual liberties,” that belief may be wrong. Shiller himself points to Switzerland as an example of a society where the homeownership rate is only half of ours (34.6% versus 66%). Switzerland is a clearly a relatively free society and a highly successful one. I also don’t buy the admittedly common view that having a landlord is necessarily “oppressive.” In most parts of the country, the rental market is highly competitive, with hundreds or thousands of landlords competing for renters’ business. An “oppressive” landlord would quickly lose customers to his rivals, or have to charge very low rent to compensate for the inconvenience he imposes. And it’s usually easier to dump a bad landlord than a bad house that you own.

Even if we somehow couldn’t maintain our freedom and cultural identity if our homeownership rate were as low as that of the Swiss, it doesn’t follow that we would suffer any great harm from the kinds of reductions in ownership rates that could realistically be expected if government subsidies were eliminated. I don’t see any reason why an America with a homeownership rate of 56% or even 46% would be significantly worse than the one that exists now. In practice, cutting out government subsidies may not even reduce the rate that far. As Shiller himself points out (without recognizing the way it contradicts his broader argument), cutting back on subsidies would probably cause home prices to fall:

America isn’t Switzerland. Our values and habits of thought are very different. Moreover, our homes are largely scattered in vast suburbs, often with distinct features. If many of these homes needed to be converted to rental units, home prices might well drop. [emphasis added]

If home prices drop, homes will become more affordable, and more people will be able to buy them – without the kinds of dubious mortgages that imperil the financial system and leave taxpayers on the hook for hundreds of billions of dollars in bailouts. That’s the upside of falling home prices.

I doubt that we really need massive government homeownership subsidies to maintain America’s national identity. But if we do, I see it as a defect of our character not a virtue. A nation like that should consider a good twelve step program; and its government should stop playing the role of enabler. As F.A. Hayek put it, “[i]t is no real argument to say that an idea is un-American, or un-German, nor is a mistaken or vicious ideal better for having been conceived by one of our compatriots.”

My congratulations to Tyler Cowen on his lovely essay in the TLS of February 26, 2010, a review of John Lanchester, “Whoops! – Why everyone owes everyone and no one can pay.” Behind the subscriber wall, alas, but it is an intriguing, elegant review and has caused me to go order the book.  (IOU rather than Whoops in the US.  Also, the Kindle edition is available since January in the US, but the physical book won’t be released until … September!  Hmm.)

I would be remiss if I did not announce that the Congressionally-chartered Financial Crisis Inquiry Commission (FCIC) will be holding expert hearings this Friday and Saturday, February 26-27, at Washington College of Law, American University, Washington DC.  The experts include some of the country’s leading economists, and it should be an impressive set of presentations.  (Late-breaking – apologies for not giving more notice – here is the press advisory and program.  Apparently it will also be simulcast over the web, if you want to follow from afar.)  (And thanks to Anna Gelpern, my WCL colleague responsible for bringing this to my school!)

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

From the FT:

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

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

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

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

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

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

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

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

One last quote from the FT quoted in the update:

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

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

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

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

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

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

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

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

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

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

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

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

I am often on the prowl for metaphors to explain things in finance law to students, and I liked this discussion today (January 20, Comment) by the Financial Times’s John Kay on the distribution of returns described in Fooled by Randomness and The Black Swan:

Some people have described the process as picking up dimes in front of a steamroller. A more vulgar account refers to a creature that “eats like a bird and shits like an elephant”. There is a more academic description: a strategy based on writing options that are substantially out of the money. But the analogy I prefer is tailgating, the practice of driving close to the bumper of the car in front at high speed.

However described, it is the same thing: a distribution of returns that produces frequent small profits punctuated by occasional very large losses. A high proportion of trading – and business – strategies in financial markets have this tailgating characteristic. I call it the Taleb distribution, after the author of Fooled by Randomness (an earlier, and better, book than the more widely read Black Swan), which gives numerous instances.

Kay makes the important point, in passing, that important parts of the financial instruments deployed in the credit crisis were not a function of not understanding the “tailgating” phenomenon:

The issue was not just that these distributions displayed Taleb characteristics: these market activities were devised with Taleb characteristics in mind.

Kay goes on to add that governments yesterday as well as today appear to creating responses that are once again premised on the tailgating distribution.

Governments themselves have become infected by tailgating behaviour. Some officials think that government guarantees of private sector liabilities don’t cost anything, because they probably won’t be called on. Others tell you that governments will make a profit on their injections of emergency funds into financial institutions. These are precise analogues of the tailgater who congratulates himself on his skilful driving. The nature of guarantees and capital injections is that they often cost you nothing, but when they do cost you they cost you loads. The taxpayers who are paying for Icelandic banks and Fannie Mae have discovered that, but the wider lesson has not been grasped. Tailgating gets you to your destination faster – except when it doesn’t.

University of Chicago economists Gary S. Becker, Steven J. Davis, and Kevin M. Murphy argue that continuing legal and regulatory uncertainty have inhibited efforts to get the economy back on track.  Among other things, uncertainty about the rules of the game discourages investment and economic risk-taking.  After surveying some evidence to support their argument, they conclude:

These facts suggest that it was a serious economic mistake to press for a hasty, major transformation of the U.S. economy on the heels of the worst financial crisis in decades. A more effective approach would have been to concentrate first on fighting the recession and laying solid foundations for growth. They should have put plans to re-engineer the economy on the backburner, and kept them there until the economy emerged fully from the recession and returned to robust growth. By failing to adopt a measured approach to economic policy, Congress and the president may be slowing the economic recovery, and thereby prolonging the distress from the recession.

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

I am no fan of populism of either the left or right-wing variety. In my view, most populist movements exploit voter ignorance and irrationality to promote policies that tend to do far more harm than good. That said, I have been pleasantly surprised by the right-wing populist reaction to the economic crisis and Obama’s policies. With rare exceptions, right-wing populists such as Glenn Beck, Rush Limbaugh, Mark Levin, and the Tea Party protesters, have advocated free market approaches to dealing with the crisis, and have attacked Obama and the Democratic Congress for seeking massive increases in government spending and regulation. They have not responded in any of several much worse ways that seemed like plausible alternatives a year ago, and may still be today.

True, much of their rhetoric is oversimplified, doesn’t take account of counterarguments, and is unfair to opponents. But the same can be said for nearly all political rhetoric directed at a popular audience made up of rationally ignorant voters who pay only very limited attention to politics and don’t understand the details of policy debates. On balance, however, the positions taken by the right-wing populists on these issues are basically simplified versions of those taken by the most sophisticated libertarian and limited-government conservative economists and policy scholars. There has been relatively little advocacy of strange, crackpot ideas or weird conspiracy theories. Indeed, efforts to paint the Tea Partiers and others as merely closet racists usually have to rely on unsupported claims about “unspoken” assumptions and subtexts. Most, if not all, of the right-wing populists would have reacted in much the same way if the policies advocated by Obama had instead been put forward by a hypothetical President Hillary Clinton or President John Edwards.

Things could have been a lot worse. For example, the right-wing populists could have reacted to Obama and the financial crisis by embracing the kind of big government social conservatism advocated by Mike Huckabee during the presidential campaign. Still worse, they could have flocked to the protectionism and nativism advocated by people like Pat Buchanan. This latter possibility would have been in line with the anti-illegal immigration hysteria that swept the populist right just two years ago. One can easily imagine a right-wing populist movement blaming high unemployment on illegal immigrant “criminals” who “steal” American jobs. By and large, however, none of this has happened. Given the inherent constraints of popular political discourse, right-wing populists have reacted to the crisis and Obama about as well as one could reasonably hope.

We should not be too optimistic. If the crisis gets worse, right-wing populism could still go off in a more unsavory direction. There is a great deal of latent prejudice and irrationality in public opinion that a nastier version of right-wing populism could exploit. For example, some 25% of Americans blame “the Jews” for the financial crisis. While racism has declined greatly in recent decades, it is still present in a significant minority of the population. Other studies show that large numbers of people embrace a wide variety of conspiracy theories about government and politics, including some that could easily be exploited in dangerous ways during times of time of crisis. In addition, I still think that right-wing populists are seriously mistaken about many important social issues. Like many other conservatives, such as Robert Bork, they often seem unaware of the contradictions between their critique of government economic regulation and their advocacy of sweeping social regulation. Here too, one can imagine some dangerous developments. For example, right-wing populists could take the position that the economic crisis is some kind of divine punishment for our immorality, and advocate stricter morals regulation as a “solution” – exactly the sort of argument that Jerry Falwell and Pat Robertson made in the aftermath of 9/11, which they claimed was God’s punishment of America for abortion, homosexuality, and feminism.

Despite all these caveats, I still believe that the right-wing populist response to the crisis and Obama is a positive development. Obviously, that’s an easy conclusion for a libertarian like me. But even if you think that their pro-limited government position is wrong, it’s still better to have an opposition that advocates free markets than one that promotes racism, protectionism, nativism, or crackpot conspiracy theories. To that limited extent, even liberals have reason to be happy about the present state of right-wing populism.

UPDATE: Some commenters think that my argument is refuted by the fact that Beck, Limbaugh and other right-wing populists were at the forefront of the anti-illegal immigration hysteria two years ago, and have not retracted their nativist statements. I am well aware of their record in this regard, and even linked an op ed that criticized Beck’s statements from that time in the original post. My point however is that this has not been a major part of their response to Obama and the economic crisis. I do not claim that they have actually become libertarian on immigration issues. I would say the same thing with respect to various other stupid or offensive things that Beck and the others have said on other issues. It is not my purpose to argue that these people are generally praiseworthy, merely that their response to the economic crisis has been a lot better than many (myself included) could have expected.

UPDATE #2: I should note, as a counterexample to my argument, Beck’s stupid remark that Obama is a “racist” who has a “hatred of . .. white culture.” Is it a counterexample I should have noticed before? Absolutely. Does it invalidate my general argument? I think not. Other right-wing populists have hardly taken up this remark or others like it as a rallying cry, and indeed Beck was immediately pounced on by the Fox News interviewer (see above link), even though Fox is surely the station of choice for right-wing populist viewers. Since then, Beck himself has had to downplay this remark and try to pretend like he didn’t really mean what he said.

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

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

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

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

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

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

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

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

In this January post, I noted some of the uncanny parallels between George W. Bush and Herbert Hoover: Both were president during a time of economic crisis; both presided over vast expansions of government that helped cause the crisis or at least make it worse than it might have been otherwise; finally both were (inaccurately) portrayed by their political opponents as dogmatic free market advocates, when in fact both were highly statist. After leaving the presidency, Bush is unconsciously imitating Hoover in yet another way – by rhetorically supporting free markets and criticizing the even more interventionist policies of his Democratic successor (which in both cases built on the expansions of government initiated by the Republicans who preceded them):

Former President George W. Bush, outlining plans for a new public policy institute, on Thursday said America must fight the temptation to allow the federal government to take control of the private sector, declaring that too much government intervention will squelch economic recovery and expansion….

“As the world recovers, we will face a temptation to replace the risk-and-reward model of the private sector with the blunt instruments of government spending and control. History shows that the greater threat to prosperity is not too little government involvement, but too much,” said Mr. Bush…

Bush’s belated support for free markets follows in Hoover’s footsteps. After leaving office in 1933, Hoover wrote books and articles defending free markets and criticizing the Democrats’ New Deal. Some of his criticisms of FDR were well-taken. Many New Deal policies actually worsened and prolonged the Great Depression by organizing cartels and increasing unemployment. But by coming out as a free market advocate, the post-presidential Hoover actually bolstered the cause of interventionism because he helped cement the incorrect impression that he had pursued free market policies while in office, thereby causing the Depression. Bush’s post-presidential conversion creates a similar risk: it could solidify the already widespread impression that he, like the Hoover of myth, pursued laissez-faire policies which then caused an economic crisis.

What should Bush now do if he genuinely wants to help the free market cause? The best thing would be to take up economist David Henderson’s half-joking suggestion that he “express his regret at nationalizing airport safety, carrying out illegal surveillance of U.S. citizens, raiding medical marijuana clinics, bailing out General Motors, AIG and other companies, and socializing prescription drugs for the elderly [the biggest new government program from the 1960s until the present financial crisis].” Bush could also point out that he advocated an ideology of “compassionate conservatism” that included vastly expanded government, and an “ownership society” that (in his own words) involved “us[ing] the mighty muscle of the federal government” to incentivize dubious mortgages of the kind that helped cause the financial collapse of 2008. The greatest contribution Bush can now make to free market policies is to dispel the impression that he pursued them while in office.

It is probably unrealistic to expect any politician to admit major mistakes or point out that he is now advocating policies vastly different from those he pursued while in office. So the second-best way for post-presidential Bush to support free markets is to say as little about the subject as possible. The more the cause is associated with him, the worse off it will be.

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

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

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

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

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

Does government interference inevitably follow government ownership of private companies?  It sure seems that way.  As a WSJ article reports: “Companies in hock to Washington now have the equivalent of 535 new board members — 100 U.S. senators and 435 House members.”  Specifically, the story reports on efforts by various lawmakers to inflence the business decisions at GM.  The story begins:

Montana Rep. Denny Rehberg was no fan of the $58 billion federal rescue of General Motors Co., saying he worried taxpayer money would be wasted and the restructuring process would be vulnerable to “political pressure.” Now the lawmaker says it’s his “patriotic duty” to wade into GM’s affairs.

Along with Montana’s two Democratic senators, the Republican congressman is battling to get GM to reinstate a contract with a Montana palladium mine nullified in bankruptcy court. “The simple fact is, when GM took federal dollars, they lost some of their autonomy,” Mr. Rehberg says.

And later in the story:

“I was elected to represent the interests of Montana, not General Motors, which is something that GM should have considered before letting the federal government assume control of their company,” Rep. Rehberg said recently.

Alas, this is but one of many tales of political interference in the once-proud automaker’s affairs detailed by the WSJ, many of which involve efforts to save politically connected auto dealerships. Stuff like this doesn’t make it likely my next car will be a GM.

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

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

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

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

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

Just when you thought the global financial crisis was subsiding, with returns to growth in most leading economies, including the US, Europe, China, etc., we have a counter-indicator.  The Financial Times reports today that McDonald’s is closing its three outlets in Iceland, citing the difficult economic environment:

Iceland edged further towards the margins of the global economy on Monday whenMcDonald’s announced the closure of its three restaurants in the crisis-hit country and said that it had no plans to return.

The move will see Iceland, one of the world’s wealthiest nations per capita until the collapse of its banking sector last year, join Albania, Armenia and Bosnia and Herzegovina in a small band of European countries without a McDonald’s.

The FT gives some background on why the environment for selling Big Macs in Iceland is so difficult:

McDonald’s blamed the closures on the “very challenging economic climate” and the “unique operational complexity” of doing business in an island nation of just 300,000 people on the edge of the Arctic Circle.  Most ingredients used by McDonald’s in Iceland are imported from Germany – leading to a doubling in costs as the krona has collapsed while the euro has strengthened.

The FT cites the Big Mac index, a purchasing power parity index for comparing the valuations of currencies based on the comparative price of a single, uniform basket of goods, in this case a Big Mac, drink, and fries (as I recall).  The Economist dreamed it up as whimsy many years ago, but it has proved oddly robust at least for certain comparisons:

Magnus Ogmundsson, managing director of Lyst, the McDonald’s franchise holder in Iceland, said that price rises of at least 20 per cent were needed to produce an acceptable profit. That would have pushed the price of a Big Mac burger well above the $5.75 it costs to buy one in Switzerland, home to the world’s most expensive McDonald’s, according to the Big Mac index.

Luckily, the local franchise owner is taking over the stores and plans to retool the menu using locally produced meat and ingredients, and rebranding under the eco-cool concept of local food production.

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

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

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

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

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

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

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