Streetwise Professor

April 7, 2009


Filed under: Economics,Financial crisis,Politics — The Professor @ 8:27 pm

If sometimes I seem a little, well, schizo, there’s a reason for that.  On the one hand (or is it personality?), I have deep Hamiltonian sympathies for commerce and industry.  Moreover, I share Hamilton’s view that finance is an essential complement to commercial and manufacturing activities, facilitating as it does the efficient allocation of resources over time and risk across individuals.  On the other hand/personality, I have strong Jacksonian instincts, with a suspicion of big government, and a healthy skepticism (if not Jacksonian hate) for large banks.

The contradiction is more apparent than real, and can be largely eliminated by an appeal to Adam Smith, via Friedman and Stigler.  As these gentlemen often pointed out, Adam Smith was a firm believer in what later came to be called capitalism, but he was deeply hostile to individual capitalists.  Smith was especially critical of large business interests’ exercise of political power to induce the government to extend them favorable privileges or trade protections.  Stigler and his followers subsequently built on Smith’s insight to argue that large, concentrated interests, especially business interests, could effectively “capture” legislators and regulators, thereby securing favorable laws and regulatory decisions.  One can therefore quite consistently be a Hamiltonian supporter of commerce, industry and finance, and a Jacksonian critic of the powers and privileges that commercial, industrial, and financial firms secure through their influence on, and perhaps capture of, the government.

This issue is of direct relevance to the financial crisis, and policy responses thereto.  In a long piece in the Atlantic, former IMF chief economist and current MIT professor Simon Johnson argues “that the finance industry has effectively captured our government—a state of affairs that more typically describes emerging markets, and is at the center of many emerging-market crises.”  

I am not particularly convinced by Johnson’s argument that capture of the government by large financial institutions led to the adoption of policies that caused the crisis.  I do agree, however, that the baleful political influence of large financial institutions is impeding the resolution of that crisis, and threatens to prolong and deepen it.  

Johnson presents a list of regulatory and legislative developments in the 90s and 00s, and suggests that these various moves to free finance from legal fetters caused the crisis:

From this confluence of campaign finance, personal connections, and ideology there flowed, in just the past decade, a river of deregulatory policies that is, in hindsight, astonishing:

• insistence on free movement of capital across borders;

• the repeal of Depression-era regulations separating commercial and investment banking;

• a congressional ban on the regulation of credit-default swaps;

• major increases in the amount of leverage allowed to investment banks;

• a light (dare I say  invisible?) hand at the Securities and Exchange Commission in its regulatory enforcement;

• an international agreement to allow banks to measure their own riskiness;

• and an intentional failure to update regulations so as to keep up with the tremendous pace of financial innovation.

The mood that accompanied these measures in Washington seemed to swing between nonchalance and outright celebration: finance unleashed, it was thought, would continue to propel the economy to greater heights.

I agree that the changes were indeed astonishing.  Some were clearly salutary (e.g., free capital flows).  Most others, (e.g., the repeal of Glass-Steagall, the Commodity Futures Modernization Act that limited–but did not eliminate, as is often asserted–regulation of OTC derivatives) contributed little if anything, in my view, to the coming of the financial crisis or its severity.  One-“an international agreement to allow banks to measure their own riskiness”–is onto something, but not primarily for the reason that Johnson highlights.  The Basel II banking regulations engendered massive efforts to move banking activities, and risk, off balance sheet, and thereby encouraged some pernicious financial engineering driven primarily by regulatory arbitrage/avoidance, rather than legitimate reasons of risk allocation.  A good example of the law of unintended consequences to keep in mind when someone glibly recommends bank capital regulation reform as a magic bullet.

Regardless of whether Johnson or I am correct, that’s water over the damn now.  What is of the moment is where do we go from here.  And in this area, I am largely in agreement with Johnson’s diagnosis that many policymakers are captured by large financial institutions; that the interests of these large financial institutions, their managers and their shareholders, are not aligned with the interests of the rest of us; and that as a result of the conjunction of these two factors, policies to address the financial crisis are dangerously off track and threaten even greater damage.  

Johnson’s analysis agrees with that which I have offered here on SWP, with respect to (a) the great dangers of allowing insolvent or nearly insolvent banks to remain in operation in such a parlous financial condition; (b) the very strong incentive of such banks to continue to operate in hopes that luck or insane gambles will restore them to solvency; and (c) the apparent success of these banks in shaping policies that have given them an unwarranted lease on life, and perpetuated their perverse operational incentives:

This latest plan—which is likely to provide cheap loans to hedge funds and others so that they can buy distressed bank assets at relatively high prices—has been heavily influenced by the financial sector, and Treasury has made no secret of that. As Neel Kashkari, a senior Treasury official under both Henry Paulson and Tim Geithner (and a Goldman alum) told Congress in March, “We had received inbound unsolicited proposals from people in the private sector saying, ‘We have capital on the sidelines; we want to go after [distressed bank] assets.'” And the plan lets them do just that: “By marrying government capital—taxpayer capital—with private-sector capital and providing financing, you can enable those investors to then go after those assets at a price that makes sense for the investors and at a price that makes sense for the banks.” Kashkari didn’t mention anything about what makes sense for the third group involved: the taxpayers.

Even leaving aside fairness to taxpayers, the government’s velvet-glove approach with the banks is deeply troubling, for one simple reason: it is inadequate to change the behavior of a financial sector accustomed to doing business on its own terms, at a time when that behavior  must  change. As an unnamed senior bank official  said to  The New York Times  last fall, “It doesn’t matter how much Hank Paulson gives us, no one is going to lend a nickel until the economy turns.” But there’s the rub: the economy can’t recover until the banks are healthy and willing to lend.

The Way Out

Looking just at the financial crisis (and leaving aside some problems of the larger economy), we face at least two major, interrelated problems. The first is a desperately ill banking sector that threatens to choke off any incipient recovery that the fiscal stimulus might generate. The second is a political balance of power that gives the financial sector a veto over public policy, even as that sector loses popular support.

Big banks, it seems, have only gained political strength since the crisis began. And this is not surprising. With the financial system so fragile, the damage that a major bank failure could cause—Lehman was small relative to Citigroup or Bank of America—is much greater than it would be during ordinary times. The banks have been exploiting this fear as they wring favorable deals out of Washington. Bank of America obtained its second bailout package (in January) after warning the government that it might not be able to go through with the acquisition of Merrill Lynch, a prospect that Treasury did not want to consider.

The challenges the United States faces are familiar territory to the people at the IMF. If you hid the name of the country and just showed them the numbers, there is no doubt what old IMF hands would say: nationalize troubled banks and break them up as necessary.

In some ways, of course, the government has already taken control of the banking system. It has essentially guaranteed the liabilities of the biggest banks, and it is their only plausible source of capital today. Meanwhile, the Federal Reserve has taken on a major role in providing credit to the economy—the function that the private banking sector is supposed to be performing, but isn’t. Yet there are limits to what the Fed can do on its own; consumers and businesses are still dependent on banks that lack the balance sheets and the incentives to make the loans the economy needs, and the government has no real control over who runs the banks, or over what they do.

At the root of the banks’ problems are the large losses they have undoubtedly taken on their securities and loan portfolios. But they don’t want to recognize the full extent of their losses, because that would likely expose them as insolvent. So they talk down the problem, and ask for handouts that aren’t enough to make them healthy (again, they can’t reveal the size of the handouts that would be necessary for that), but are enough to keep them upright a little longer. This behavior is corrosive: unhealthy banks either don’t lend (hoarding money to shore up reserves) or they make desperate gambles on high-risk loans and investments that could pay off big, but probably won’t pay off at all. In either case, the economy suffers further, and as it does, bank assets themselves continue to deteriorate—creating a highly destructive vicious cycle.  

The fundamental problem is that insolvent banks face very perverse incentives, and as a result (a) tend to dissipate wealth rather than build it, and (b) banking problems tend to metastasize, with persistent, pernicious effects on the broader economy.  There are a variety of approaches to address this problem.  Johnson advocates nationalization.  Others advocate variants on the good bank-bad bank approach. I’ve added the Humpty-Dumpty twist to the good bank-bad bank alternative.  Although these approaches differ in detail, they all involve some common elements, most notably isolating bad assets, and forcing the restructuring of insolvent institutions (whose insolvency is typically revealed only after the full extent of their bad asset holdings is recognized by stripping out these assets).  This restructuring typically wipes out shareholders, leads to the departure of top management, and can also impose losses on debtholders.  That is, it forces the claimants of insolvent banks, and the holders of their residual control rights, to internalize the costs of insolvency.  Banks shareholders, bondholders, and managers, however, have every incentive to try to externalize those costs.  The gambling to survive option is the most effective way to do that, and that is precisely why recent policy changes, including many features of the Geithner plan, and the recent FASB rule change on accounting for some assets, are so troublesome: these policies enable insolvent banks to extend their lives, and indulge their bad incentives for who knows how much longer, and at what cost.  

As I wrote last week, there are some rumblings from within the administration that suggest that the capture is not complete.  In particular, statements that banks would be forced to write down assets, or to sell them into the Geithner bad loan and bad securities programs, give reason to believe that the administration is aware of the perverse incentives inherent in the black-and-white of the Treasury plan, and intends to take away with regulatory pressure the options that the Treasury blueprint and the new accounting rules have given.  

But that is just a conjecture, and one that gives the administration the benefit of the doubt.  Actions speak louder than words.   Until the banks squeal very loudly that they are being driven to the wall by Treasury or FDIC dictates to sell bad assets, thereby revealing to all the extent of their financial position (insolvent or no?), I will continue to believe, along with Simon Johnson, in the literal words of the Treasury plan.  Those words give tremendous discretion to banks with bad incentives.  That screams capture, and bodes ill for the future.

And even if the Treasury and Fed and FDIC are truly being Machiavellian, taking away through left-handed pressure the optionality that Treasury extended with the right hand of the PPIPs program, it would be much more comforting if it acted in a straight-forward manner.  It would provide a stronger signal that they are in fact not prisoners of the bad banks.  And what’s more, due to their political power and influence, it is quite possible that they will be able to deflect, if not defeat altogether, pressure that the government attempts to bring to bear.  

This should give pause to those that view “more regulation” as a mantra that will fix all of our problems.  That is a dreamy vision of regulation, that works in Nirvana, but not here on earth.  On earth, individuals and firms with large sums at stake and superior information almost invariably shape regulation to their benefit.  Both conditions hold in banking today, and given the complexity of modern financial institutions and the products they trade, the informational advantages of the banks over legislators, let alone the GS 12s, 13s, and 14s expected to bring them to heel, are immense.  It is wildly optimistic to expect that the normal operations of politics and regulation will lead to an outcome that is not far too beneficial for banks, their shareholders, their bondholders, and their executives.

That is, the problem is an economic one, but its solution is at heart a political one.

And maybe that brings us back to Andrew Jackson.  Jackson exerted enormous political power to undermine the Second Bank of the United States, an institution that had been associated with (believe it or not) extremely lax credit policies that fed a speculative land boom and endemic corruption.  The deeply libertarian Jackson believed that the BUS was a threat to both the economy, and American political liberty.  He prevailed in a titanic political struggle against Nicholas Biddle (the bank’s president), Henry Clay, and Daniel Webster.  

Now, Jackson’s banking policy as a hole was hardly admirable, but his actions do indicate that capture is not inevitable.  But there is room for considerable doubt whether anything remotely Jacksonian is likely to come out of Washington today.  Which means that the regulatory capture that Simon Johnson laments may be with us for a long time, with baleful consequences.

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