(Note: I was writing this on the plane without quite being able to see the computer screen, so I’ve gone back and corrected some grammar and spelling, and tried to make a couple of things clearer. I’ll post separately as well on the topic of national security and the financial crisis, and the role of executive discretion in responding. But I also wanted to note that over at The Conglomerate, the compadres there are also having a discussion of Professor Skeel’s book, including my friend David Zaring, who, along with the redoubtable Steven Davidoff, was responsible for a seminal article and concept in this question of discretionary regulation, “Regulation by Deal.”)
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.