Streetwise Professor

March 25, 2009

Growing Leviathan

Filed under: Economics,Financial crisis,Politics — The Professor @ 4:02 pm

Bernanke and Geithner testified before Congress yesterday, and advocated the creation of vast new Federal powers to intervene in financial markets.   These powers (soothingly called “resolution procedures”) would include the ability to seize “systemically important nonbank financial firms.”   In particular, the government would be empowered to place such a firm “into conservatorship or receivership, unwind it slowly, protect policyholders, and impose haircuts on creditors and counterparties as appropriate” (Bernanke) and “to sell or transfer the assets or liabilities of the institution in question, renegotiate or repudiate the institution’s contracts (including with its employees), and prevent certain financial contracts with the institution from being terminated on account of the conservatorship or receivership” (Geithner).

This would represent a breathtaking expansion of government authority.   Such power can be used for ill by venal, unscrupulous, vindictive, or power mad politicians.   Think of this authority in the hands of an Elliot Spitzer-type, or an Andrew Cuomo-type.   Hell, think of what Harry Truman could have done with it during his battle with steel companies in the Korean War.   Moreover, merely rational politicians may respond to populist pressures, or to interest group pressure, to utilize these powers in a way that helps the politician, but not the broader interests.   These powers can also be used for ill by well-meaning, but incompetent officeholders.   The performances of Henry “Trust me, I stayed at a Holiday Inn Express Last Night” Paulson or Geithner or Bernanke hardly inspire confidence that such powers will be wielded wisely.

Bernanke briefly genuflected to bankruptcy law, but then dismissed its relevance, arguing that it was too cumbersome to deal with fast-breaking crises like that that engulfed AIG.

In essence, Bernanke and Geithner are pressing for what the property rights economics literature calls state contingent control rights.   Private contracts and the law (e.g., bankruptcy law) also have mechanisms to allocate control rights on a state contingent basis.   For instance, when certain events occur (e.g., a corporate debtor cannot make a payment), rights of control over assets are shifted.   Efficiency considerations provide incentives for parties to design transfer mechanisms that respect information asymmetries and costs, and other transactions costs.   Moreover, these mechanisms also provide protections against opportunistic actions that impair efficiency, but allow one party (or parties) to extract wealth from others.

Bernanke and Geithner pointed to Federal powers to force banks into receivership as a precedent for their request to obtain similar powers over other institutions.   It is important to note, though, that there is a crucial difference.   Government, via deposit insurance, is effectively a direct claimant against an insured bank.   An insolvent bank has incentives to act in ways that is detrimental to the interests of this claimant, and others as well.   Just as bankruptcy law serves to protect creditors against the inefficient actions of shareholders and managers, the ability of the government to intervene protects the government and taxpayers as creditors against the inefficient actions of insolvent banks and their managers.   Note that most of the banks seized in this fashion are small and not systematically important.   This illustrates that this mechanism serves less as a mechanism of systemic protection, but as a means of protecting one class of creditors.

I would also emphasize the breathtaking hypocrisy in this proposal.   Systemically important banks are at the heart of the current financial crisis.   Sure, AIG is a big deal, but so are Citi, BofA, etc.   The government already has considerable power over these banks.   Arguably, it should be using it to control systemic risk, not to mention to limit the exposure of the FDIC as deposit insurer.   But it seems that every action of the Treasury and Fed is consciously intended to avoid taking forceful action.

In their testimonies, neither Geithner or Bernanke specified the kinds of safeguards that would be in place to protect the intertests of affected parties in the event of a government intervention.   Given that government especially is often first and foremost a mechanism for rent seeking, it is imperative that such mechanisms exist.

AIG was the poster child for the Bernanke-Geithner arguments.   One interpretation of their remarks is that the government lacked the authority to impose haircuts on creditors and counterparties, and hence were forced to use government funds to make these firms (e.g., Goldman) whole.   That seems a real stretch.   It seems more likely that the AIG outcome reflected the influence of some firms and interests, and the lack of influence of others.   From this perspective, it is quite likely that the outcome would be the same even if the government had the power to impose a haircut on Goldman or not.   I think that if Paulson and Bernanke had wanted to get AIG derivatives counterparties to share the pain, they could have found the way.   The fact that they didn’t was, in this view, a conscious choice, rather than the result of a lack of the ability to make a different choice.

The power to impose unilaterally contractual adjustments that will influence the allocation of tens of billions of dollars is an awesome one.   It needs serious ringfencing to protect the interests of the myriad claimants of these “systemically important” firms.   Thus, rather than delegating vast powers to the Executive Branch, or the Fed, it would be worthwhile to see how bankruptcy law can be modified to permit more timely intervention while respecting the interests of affected parties against the potentially malign or incompetent actions of the government.   Moreover, an established procedure could reduce uncertainty, which is an important benefit during times of systemic stress.

There’s another thing to be considered.   What will be the equilibrium consequences of such a massive shift in control rights?     Given such a shift in the contracting environment, private parties will adjust their contracts.   They may try to contract around the restrictions in ways that could have serious implications both during a systemic event, but also in “ordinary” times.   How will granting these conditional control rights to the government affect private contracting decisions relating to capital structures?   Employment contracts?   Compensation structures?   How will it affect the sizes of firms?   Their horizontal and vertical scopes?   (I can see, for instance, this leading to an increase in vertical integration, as arms length contracts face additional risks under the Bernanke-Geithner proposal.)   How will it affect other kinds of financial contracting, e.g., collateralization, the use of derivatives, the use of clearinghouses?

I don’t know the answers to these questions.   Many are likely unanswerable ex ante.   But it must be recognized that the unintended effects of this expansion of power are likely to be huge, and deserve consideration ahead of time.   Marry in haste, repent at leisure is not a wise course to follow.   Many of the proposals for regulatory and legislative changes, these included, seem predicated on the view that nothing else will change in response to these changes.   We know that is wrong.   We also know that many of the equilibrium responses of private parties will be individually rational, but reduce efficiency.   The Bernanke-Geithner proposals will not only affect what happens during a systemic event, but what happens every day after they are implemented.   The cumulative impact of these seemingly small changes in individual contracting decisions could be greater than the impact arising from the effect of the proposed regulations on the problem at hand–controlling systemic risk.   I would hope that some serious thought is given to this issue before we put the current crisis to use to vastly expand the government’s power in the next one.

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