Streetwise Professor

Oliver Williamson, the premier transactions cost economist, coined many neologisms and succinct phrases.  One of them is “selective intervention.”  This concept means that managers cannot credibly commit to utilize discretion to intervene only when this is economically efficient.  The inability to commit to use discretion efficiently is, in Williamson’s view, one of the factors that limits the size of firms.  It is also why imposing ex ante constraints on decision makers can enhance efficiency even though these constraints are costly ex post.  It is, in brief, why rules are frequently superior to discretion.  

The outrage over the AIG bonuses provides a particularly acute illustration of the dilemmas that arise with selective intervention.  (The UK has screened a similar soap opera in recent weeks, involving the pension of RBS’s Sir Fred Goodwin.)  Assume arguendo (a common Williamsonian trope) that revoking the AIG bonuses is an efficient use of government discretion.  Can any financial institution, or any business for that matter, be assured that if it accepts government assistance, that the government will use its discretion to intervene to change contracts or alter management decisions only when efficient?  Or, would it be more reasonable for said institution or said business to conclude that policymakers acting according to political, rather than economic, calculus, will frequently abuse their discretion, and implement politically popular but inefficient decisions?  

Given the sums at stake in the ongoing financial crisis, the selective abrogation of contracts, no matter how outrageous they appear ex post, is likely to result in costs that dwarf the hundreds of millions in bonuses due to the employees of AIG Financial Group.  In particular, it would likely lead to a dramatic increase in the difficulty of negotiating workouts or recapitalization or restructuring of other troubled financial institutions.  Delays in such measures could have immense real costs.  Costs, by the way, that would fall on everyone, as taxpayers but also just as economic agents (due to the adverse effects on the overall economy).  Moreover, the uncertainty associated with the use of discretion can impair private decision making and investment.  (Why make an irreversible investment when a subsequent exercise of government discretion could lead to its effective expropriation?)  This again imposes substantial costs across the entire economy.  

Under these circumstances, there is a strong case to be made for relying on rule-based, rather than discretionary, responses to the distress of large financial institutions.  If the government, as the residual claimaint of AIG, has a legitimate legal justification for eliminating or reducing the AIG bonus payouts, there are established legal rules and procedures for achieving that outcome.  And no, this doesn’t mean Spitzer-like granstanding and armtwisting by Andy Cuomo.  It means a methodical pursuit of redress through real courts, not through the court of public opinion.  

It also means that there should be a strong preference for existing, rule-based mechanisms, such as FDIC receivership and bankruptcy procedures.  

This episode provides a very illuminating illustration of the costs associated with the ad hoc (read, discretionary)  way in which the government has addressed the financial crisis.  At its very outset, there was some justification for this, as there was room for serious doubt that existing rule-based institutions were capable of dealing with unprecedented crises in real time.  But 6 months have passed since Lehman and AIG, 9 or so since Fannie and Freddie, 12 since Bear.  The new administration has been in place for 3, and its senior financial policy team since the election.  Given these experiences, and the time that has lapsed, we should be far further along in creating a legal and regulatory structure for addressing large, troubled financial institutions.  Instead, we seem to be pretty much where we were a year ago.  

To the extent possible, this should cleave to existing precedents in bankruptcy law, and in FDIC procedures and regulations.  These things are messy, no doubt.  (Having been involved in several bankruptcy cases as an expert, I have first hand experience with this.)  But they are messy in a somewhat predictable way, and in a way that limits the potential for abuse of discretion.

At cynical moments (and I have many, if you haven’t noticed;-) I wonder if this is a feature, not a bug, at least from the perspective of those in government.  To them, discretion is a good, not a bad.   Sovereigns always bridle at the restrictions of law, precedent, and procedure, even though these often lead to substantial increases in wealth and efficiency.    

The bonus fiasco also shows the problematic rationale for the entire AIG bailout.  It is clear that the Treasury and Fed felt compelled to support AIG, rather than let it implode, in order to protect its counterparties, who happened to be large, systemically important financial institutions (e.g., Goldman).  But supporting these institutions indirectly, by funneling money through AIG, rather than in a more direct way, has created a huge agency problem.  AIG has become, in effect, the government’s agent in maintaining the solvency of other large financial institutions.  But AIG and its managers have their own agendas, and their interests and incentives are not well aligned with those of the other large financial institutions, or with the taxpayers who are ultimately on the hook in this arrangement.  Using AIG as a conduit for taxpayer financial support to other institutions has added substantial friction to the process.

It would be far more efficient to take AIG out of the middle of this process of channeling billions from taxpayers to financial institutions.  This would require novating AIG’s trades.  Maybe the government should become the counterparty.  Or, it could novate the deals to other institutions and provide credit support.  Or it could negotiate closeouts, perhaps requiring the in-the-money counterparties to take a haircut.  All of these alternatives pose challenges, but it is almost certain that these challenges entail lower costs than the agency costs incurred using AIG as a conduit to keep its counteparties whole.  In other words, cut out the middleman.

A constant theme of my Russian commentary is that the absence of a rule of law; the insecurity of contractual and property rights; and the abuse of discretion by a state only weakly bound by procedural checks and balances; have all contributed to that nation’s economic dysfunction.  No doubt one can make an argument that this or that Russian state intervention was efficient, but there is no doubt that the vast scope of state discretion has been detrimental to Russian economic development.  Similarly, a strong argument can be made that the AIG bonuses are unconscionable, and inefficient in light of current information.  But as in Russia, the cost of weakening the rule of law in general, and contract rights in particular, will far exceed the benefits of a legally dubious discretionary intervention.  

As in many situations, we face a choice of evils.  Given the essential role of the rule of law in binding Leviathan, in my mind the far greater evil is an erosion of the security of property and contract rights.  We don’t want a nation where government officials can threaten to send corporate executive to the doctor for having the temerity to do something that offends the Sovereign.  Several hundred million dollars is a lot of money.  But it pales in comparison to the amount that would be lost by undermining contracts and the rule of law.