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Sunday, January 17, 2010

"Please Sir, May We Have Some Justice?"

Maxine Udall:

Please, sir, may we have some justice?, by Maxine Udall: We have just witnessed highly compensated investment bankers asserting that they are the clueless victims of an unforeseeable, unpreventable hundred year financial crisis (except when it happens every five to seven years).
Until last year, Maxine had always assumed that at least one reason for investment bankers' high compensation was that the market had chosen to reward them for competence and knowledge about high finance, things we lesser mortals couldn’t possibly grasp with our mundane, tiny little minds. Now we find out that they apparently hadn’t even grasped the basics... “The higher the returns, the higher the risk, and if the returns are high and sustained, you’re in a Ponzi scheme or a bubble. ...” ...
It seems so basic and no amount of clever math and models can really change it...: Higher returns means higher risk and if the returns are high and sustained, you’re in a Ponzi scheme or a bubble.
We and our elected representatives have a choice to make. We can continue to compensate clueless victims way beyond the value of their marginal product in any domain of productivity you care to name and we can continue to allow them to cluelessly manage financial institutions for their own short-term short-sighted gains until they plunge the rest of us into serfdom or we can change how they are compensated and maybe even who is compensated (as in throw the bums out) and we can change the rules by which they are allowed to "play" with our money.
The latter shouldn’t be rocket science were it not for the wealth and power bankers are able to exert in their own interest. If the political will is not there now to do this, for heaven’s sake, when will it be????
Oh, right...after a full-blown depression, like last time.
But even then, reform and regulation will not be enough. We need a new language about business and markets that is sensible and grounded in reality. In the last thirty years, both have been elevated to near religion, with financiers and CEOs as high priests.
Something has been lost in that transformation. When Adam Smith wrote about the value and advantages of commercial society, he saw all of society (and, of course, was comparing it to the vestigial remains of feudalism which set a very low, preliminary standard). He wrote about how even those at the bottom were made better off. He appeared to care about them. He worried that because of the drudgery of the work at the lower end of society, people in those roles would require additional inputs, like education, paid for by the larger society. He viewed the entire wealth of the nation including the distribution not only of wealth but of opportunity (admittedly within the confines of a rather rigid class structure). And he was quite critical of the ne’er-do-well rich and of businessmen who colluded to extract welfare from consumers in the form of higher prices.
Perhaps most importantly, Adam Smith appears to have understood the value of the moral side effects of commercial transactions: trust, sympathy for our fellow tradesmen and women, for our customers, for our neighbors, a sense of community and of the common good, all traded in the marketplace along with the money, goods, and services that change hands. He recognized the interdependencies that markets create and reinforce, interdependencies that bind us to common objectives and that lower the transaction costs of achieving them.
So you see it isn’t just about the money. ... It’s about the moral side effects of market transactions and exchange. Morally clueless investment bankers have trashed the fabric that binds us together as a nation. They have sent a message loud and clear that short-sighted, immoral cluelessness that serves only one’s own short-run self-interest is what is rewarded. That unearned wealth, power and prestige have more political and economic currency than the hard-earned trust, confidence, and lower profit margins of honest businessmen embedded in, committed to, and serving their customers and their communities. ...
Moral, socially responsible, honest (usually small) businessmen and women ... provide some of the moral glue that holds us together. Market forces in small, truly competitive, transparent markets (which financial markets most definitely are not) often reinforce the moral glue and sometimes even provide it by reining in the Mr. Potters and the Gyges of the world.
Mr. Potter testified last week, pockets bulging with cash earned on the backs of the people of Bedford Falls, that he is clueless and incompetent and that stuff happens. He harmed Main Street, both the people who shop there and the people who own businesses there. He harmed the backbone of our democratic society. We bailed him out. Isn’t it time we held him to account?
We can reduce the moral hazard we’ve created with a no-strings bailout, we can reduce the moral side-effects of the moral hazard, and we can help Main Street. Let’s start by using all the bonus money to extend the safety net for unemployed workers, please. Then let’s tax the finance sector’s inordinate Ponzi scheme profits and use the proceeds to build new infrastructure and to retool the US workforce for the 21st century. And for God’s sake, let's regulate Mr. Potter.  Let’s take a longer-term view of economic and societal well-being. Let’s make something good from this that will benefit our grandchildren.
Please, sir, may we have some justice?

Businesses will do whatever they can to give themselves an advantage over their customers and increase profits. How can we level the playing field? Adam Smith believed that competition was the best regulator of economic behavior. You can't trust government to intervene and protect people because the rich and powerful will bend government to satisfy their needs. We should rely upon competition instead, that's our best chance of making these markets work for everyone, not just one side of the transaction.

It's easy to make the case that the financial system does not satisfy or even closely approximate the conditions necessary for the textbook version of "pure competition," conditions that must be present if markets are going to maximize social welfare in the textbook fashion. For example, pure competition calls for free entry and free exit. Have we seen free exit among too big to fail firms? Pure competition calls for a large number of firms, none of which is big enough to influence market conditions on its own. Do those conditions exist? Pure competition requires that all parties in transactions be equally informed, but that certainly wasn't the case in these markets. The list of violations of the conditions for pure competition is a long one, too long to list here extensively, but there is little doubt that substantial departures from ideal conditions were present and pervasive in the financial industry.

There was a time when I would have called for us to reestablish competitive conditions in the financial industry as a means of fixing the problems that led to its breakdown. I still think that is an important part of the solution -- I think the consequences of departures from pure competition in these markets are larger than most people recognize -- and it is part of what is behind my calls to reduce banks to their minimum effective size. But is competition enough to fix the problems? If it is enough, can we actually achieve an adequate approximation of pure competition in this industry?

 I have lost my "faith" that competition alone is enough to regulate these markets (I find that sentence surprisingly hard to write and do not wish to assert it for all markets). Regulation, particularly regulation that reduces the impact on the broader economy if the financial industry implodes again (and it will) is essential. Perhaps the test that led to this conclusion was unfair since, as just noted, the conditions in financial markets were nowhere near competitive. If we could actually establish competitive conditions in these markets, maybe they'd be fine. It's hard to say because I don't think those conditions were present in financial markets, and I've come to doubt that they can ever be present.

Some people argue that these firms are natural monopolies (or that there's only room for a few fully efficient firms). I don't think they are, but if so, they should be heavily regulated just like any other natural monopoly. In any case, natural monopolies or not, over time these markets appear to tend toward concentration rather than competition, and inherent and important market failures do not appear to self-correct (e.g., to name just one, participants in these markets do not consider the externalities their failure would impose on the broader economy as they decide how much risk to take on, or, to say it another way, how much capital to hold in reserve).

If we could overcome these market imperfections, would competition be enough to maximize the safety of these markets? I don't know because an approximation of the textbook conditions for pure competition have never existed in this industry, and the structure of the industry works strongly against such conditions ever existing. If that's the case, if we are unsure that competition would be enough to fully protect us, and if we are unsure that we can get to those conditions and then maintain them in any case, then the important role that these markets play in our economy makes it essential that we insulate ourselves from the consequences of this happening again.

I don't think we can ever fully guarantee that we are safe from collapse in the financial industry (though we should do our best to prevent it), but we can reduce the consequences if and when the financial system does collapse again. That's why I've been emphasizing broad measures such as limiting leverage/increasing capital requirements/increasing margin requirements (which all amount to the same thing), measuring and limiting interconnectedness, etc., rather than trying to identify and fix specific problems. The individual problems are important and need to be addressed, that will reduce the likelihood of collapse so I don't mean to ignore them, but insulation from big shocks and widespread collapse comes mainly through the more broad-based measures.

    Posted by on Sunday, January 17, 2010 at 12:45 PM in Economics, Financial System, Market Failure, Regulation | Permalink  Comments (21)


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