Category Archive for: Market Failure [Return to Main]

Wednesday, February 24, 2010

Reich: Bust the Health Care Trusts

Health insurance markets are "highly concentrated," but that could change:

Bust the Health Care Trusts, by Robert Reich, Commentary, NY Times: My health insurer here in California is Anthem Blue Cross. So far, my group policy hasn’t been affected by Anthem’s planned rate increase of as much as 39 percent for its customers with individual policies — but the trend worries me, as it should everyone. Rates are soaring all over the country. Insurers have been seeking to raise premiums 24 percent in Connecticut, 23 percent in Maine, 20 percent in Oregon and a wallet-popping 56 percent in Michigan. How can insurers raise prices as much as they want without fear of losing customers?
Astonishingly, the health insurance industry is exempt from federal antitrust laws, which is why a handful of insurers have become so dominant in their markets that their customers simply have nowhere else to go. But that protection could soon end: President Obama on Tuesday announced his support of a House bill that would repeal health insurers’ antitrust exemption, and Speaker Nancy Pelosi signaled that she would put it toward an immediate vote. This is promising news. ...
Health insurers ... are making boatloads of money. America’s five largest health insurers made a total profit of $12.2 billion last year; that was 56 percent higher than in 2008... It’s not as if health insurers have been inventing jazzy software or making jet airplanes. Basically, they just collect money from employers and individuals and give the money to providers. In most markets, consumers wouldn’t pay this much for so little. We’d find a competitor that charged less and delivered more. What’s stopping us? Not enough choice.
More than 90 percent of insurance markets in more than 300 metropolitan areas are “highly concentrated,” as defined by the Federal Trade Commission... A 2008 survey by the Government Accountability Office found the five largest providers of small group insurance controlled 75 percent or more of the market in 34 states, and 90 percent or more in 23 of those states, a significant increase in concentration since the G.A.O.’s 2002 survey. ...
With size has come not only market power but political clout. Big for-profit insurers deploy enough campaign money and lobbyists to get their way with state legislators and insurance commissioners. ... These companies have even been known to press states to limit how many other health insurers they license.
And when they can’t get their way, insurers go to court. In Maine — one state that aggressively regulates rates — WellPoint’s Anthem subsidiary has sued the insurance superintendent for reducing its requested rate increase.
Political clout can be especially advantageous at the federal level, as the big Wall Street banks have so brazenly demonstrated. Over the past two and a half years, WellPoint’s employees and associates have contributed more than $922,000 to federal political campaigns, and the company has spent $7.8 million lobbying Washington policymakers... It should not be surprising that WellPoint was one of the leading opponents of the public insurance option, which would have subjected it to competition even where it had sewn up the market.
Antitrust is no substitute for broader health care reform, but it’s an important prerequisite. If a handful of giant health insurers are allowed to dominate the industry, many of the other aspects of reform (establishing insurance exchanges, requiring people to have insurance, even allowing consumers to buy insurance across state lines) won’t bring down the price of insurance.
Regardless of what happens at the White House’s health care meeting on Thursday, we’ve got to make sure health insurers compete for every one of our dollars. ...

The build up of excessive market power in some industries, and the failure of regulators to step in and do something about it based partly upon attitudes toward deregulation that began in the 1970s, has been frustrating to observe. But in financial, health care, and other markets that slowly seems to be changing.

Friday, February 19, 2010

Paul Krugman: California Death Spiral

The recent, large increases in health insurance premiums in California demonstrate the need for "comprehensive, guaranteed coverage":

California Death Spiral, by Paul Krugman, Commentary, NY Times: Health insurance premiums are surging — and conservatives fear that the spectacle will reinvigorate the push for reform. On the Fox Business Network, a host chided a vice president of WellPoint, which has told California customers to expect huge rate increases: “You handed the politicians red meat at a time when health care is being discussed. You gave it to them!”
Indeed. Sky-high rate increases make a powerful case for ... comprehensive, guaranteed coverage — which is exactly what Democrats are trying to accomplish.
Here’s the story: About 800,000 people in California who buy insurance on the individual market — as opposed to ... through their employers — are covered by Anthem Blue Cross, a WellPoint subsidiary. These ... people ... were recently told to expect dramatic rate increases,... as high as 39 percent.
Why the huge increase? It’s ... a classic insurance death spiral.
Bear in mind that private health insurance only works if insurers can sell policies to both sick and healthy customers. If too many healthy people ... take their chances and remain uninsured, the risk pool deteriorates, forcing insurers to raise premiums. This ... leads more healthy people to drop coverage, worsening the risk pool even further, and so on.
Now,... cash-strapped Californians have been dropping their policies or shifting into less-comprehensive plans. Those retaining coverage tend to be people with high current medical expenses. And the result, says the company, is a drastically worsening risk pool: in effect, a death spiral.
So the rate increases, WellPoint insists, aren’t its fault... Indeed,... there have been steep actual or proposed increases in rates by a number of insurers.
But ... suppose..., provisionally, that the insurers aren’t the main villains... Even so, California’s death spiral makes nonsense of all the main arguments against comprehensive health reform.
For example, some claim that health costs would fall dramatically if only insurance companies were allowed to sell policies across state lines. But California is already a huge market, with much more insurance competition than in other states; unfortunately,... competition hasn’t averted a death spiral. So why would creating a national market make things better?
More broadly, conservatives would have you believe that health insurance suffers from too much government interference. ... But California’s individual insurance market is already notable for its lack of regulation...
Finally, there have been calls for minimalist health reform that would ban discrimination on the basis of pre-existing conditions and stop there. It’s a popular idea, but ... a ban on medical discrimination would lead to higher premiums for the healthy, and ... more and bigger death spirals.
So California’s woes show that conservative prescriptions for health reform just won’t work.
What would work? By all means, let’s ban discrimination... — but we also have to keep healthy people in the risk pool, which means requiring that people purchase insurance. This, in turn, requires substantial aid to lower-income Americans so that they can afford coverage.
And if you put all of that together, you end up with something very much like the health reform bills that ... passed both the House and the Senate.
What about claims that these bills would force Americans into the clutches of greedy insurance companies? Well, the main answer is stronger regulation; but it would also be a very good idea, politically as well as substantively, for the Senate to use reconciliation to put the public option back into its bill.
But the main point is this: California’s death spiral is a reminder that our health care system is unraveling, and that inaction isn’t an option. Congress and the president need to make reform happen — now.

Tuesday, February 09, 2010

"Fine Print, Deceptive Pricing, and Buried Tricks"

How bad is the asymmetric information problem in credit card markets? This is from Wall Street's Race to the Bottom, by Elizabeth Warren, arguing for a Consumer Financial Protection Agency. She describes what happened when Citigroup offered its credit card customers a better deal:

Wall Street executives explain privately that they cannot get rid of fine print, deceptive pricing, and buried tricks unilaterally without losing market share.
Citigroup ... in 2007 ... decided to clean up its credit card just a little bit by eliminating universal default—the trick that allowed it to raise rates retroactively, even for consumers that did nothing wrong. Citi's reform resulted in lower revenues and no new customers, triggering an embarrassing public reversal.

Citi explained sheepishly that credit cards were now so complicated that customers couldn't tell when a company offered something a little better. So Citi went back to something a little worse...

[See also Elizabeth Warren Calls Out Wall Street by James Kwak.]

Tuesday, January 19, 2010

Is It Time for Obama to "Pick a Fight with the Banks"?

I don't put much of the blame for the financial crisis on the bad incentives embedded in executive pay structures. But that doesn't meant that pay structures didn't contribute to the problem. And it certainly doesn't mean that executive pay is justified by productivity, or that there are no important market failures associated with the way executive pay is structured:

The CEO Pay Slice, by Lucian Bebchuk, Martijn Cremers, and Urs Peyer, Commentary, Project Syndicate: ...In our recent research, we studied the distribution of pay among top executives in publicly traded companies... Our analysis focused on the CEO “pay slice” – that is, the CEO’s share of the aggregate compensation such firms award to their top five executives.
We found that the pay slice of CEOs has been increasing over time. Not only has compensation of the top five executives been increasing, but CEOs have been capturing an increasing proportion of it. The average CEO’s pay slice is about 35%,... typically ... more than twice the average pay received by the other top four executives. Moreover, we found that the CEO’s pay slice is related to many aspects of firms’ performance and behavior.
To begin, firms with a higher CEO pay slice generate lower value for their investors..., such firms have lower market capitalization for a given book value. ... Moreover, firms with a high CEO pay slice are associated with lower profitability. ...
What makes firms with a higher CEO pay slice generate lower value for investors? We found that the CEO pay slice is associated with several dimensions of company behavior and performance that are commonly viewed as reflecting governance problems.
First, firms with a high CEO pay slice tend to make worse acquisition decisions. ... Second, such firms are more likely to reward their CEOs for “luck.” They are more likely to increase CEO compensation when the industry’s prospects improve for reasons unrelated to the CEO’s own performance... Financial economists view such luck-based compensation as a sign of governance problems.
Third, a higher CEO pay slice is associated with weaker accountability for poor performance. In firms with a high CEO pay slice, the probability of a CEO turnover after bad performance ... is lower. ... Finally, firms with a higher CEO pay slice are more likely to provide their CEO with option grants that turn out to be opportunistically timed. ...
What explains this emerging pattern? Some CEOs take an especially large slice ... because of their special abilities... But the ability of some CEOs to capture an especially high slice might reflect undue power and influence over the company’s decision-making. As long as the latter factor plays a significant role, the CEO pay slice partly reflects governance problems. ...
[O]ur evidence indicates that, on average, a high CEO pay slice may signal governance problems that might not otherwise be readily visible. Investors and corporate boards would thus do well to pay close attention not only to the compensation captured by the firms’ top executives, but also to how this compensation is divided among them.

Which opens the door to ask the question, is it time for Obama to pick a fight with the banks?:

Whatever happens today in Massachusetts, finding 60 votes in the Senate for meaningful financial regulatory reform is likely impossible. That means it is now high time to jettison the middle road, and go full bore against the banks. Given Obama's cautious approach so far in his administration, it is difficult to feel any confidence in such a prospect, but really, at this point one has to ask, what's he got to lose?

We've got a lot to lose if we don't get meaningful financial reform, so just as with health care, if what we can get through Congress actually improves conditions in financial markets, we need to take what we can get and hope to build upon it later. The question is how to construct a political strategy that will allow us to get as much done as possible. It may be that aggressively going after big banks can create public support for reform, support that would be difficult for politicians of either party to ignore. But there's also a chance that such a strategy will harden the resolve of those now opposed to reform making it harder to get anything done at all.

So a second question is whether the baseline level of reform we could get without an all out, "jettison the middle road" strategy is acceptable, If it is, I'd prefer to protect that and proceed cautiously. My loss function is asymmetric. Getting something, even if it isn't as much as we'd like, is much better than nothing at all.

But my sense is that right now the administration can't get enough support to do anything except fairly cosmetic changes. If that's the case, and I'm not completely sure that it is, but if so, then hammering the big banks relentlessly may be the only chance we have to create the coalition needed to implement more meaningful measures.

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.

Thursday, January 14, 2010

Market Evangelists

This is part of Robert Solow's review of How Markets Fail: The Logic of Economic Calamities written by John Cassidy:

Hedging America, by Robert M. Solow: ...[I]n the course of producing and distributing goods and services, market outcomes generate incomes, wealth, status, and power. Any modification of market outcomes modifies the allocation of incomes, wealth, status, and power. So it is no wonder that the discussion has become thickly encrusted with ideology. And one convenient way to turn subtle argument into ideology is to create dichotomies where there are originally fine gradations of more and less. For example: are you for or against “the free market”?
Today, of course, no one is against markets. The only legitimate questions are: What are their limitations? Can they go wrong? If so, how can we distinguish the ones that do from the ones that don’t? What can be done to fix the ones that do go wrong? When is some regulation needed, how much, and what kind? ...
To begin..., if a market economy is to be advertised as doing an acceptable job, we need a definition of a good economic outcome.
The standard version says that one allocation of goods and services to individuals (call it A) is better than another (B) if everyone is at least as well off (in his or her own estimation) in A as in B, and at least one person is better off. So there is to be no trading off of one person’s well-being against another’s. That sounds fair; but notice that judgments about inequality are ruled out: if everyone is equal but poor in A, and B differs only by making one person fabulously rich, B is better than A. That sounds a little less appetizing, but this extreme case underscores the individualistic nature of the whole exercise: nothing is supposed to matter to anyone but his or her own access to goods and services. Notice also that, by this definition, most As and Bs simply cannot be compared: some people are better off and some worse off in A than in B, so neither is “better” than the other.
The next step is to say that such an allocation is “efficient” if no feasible allocation can leave everybody at least as well off as they were and make somebody better off. In other words, there is no “better” allocation. You would like your economy to lead to an efficient outcome. There are many efficient allocations, some egalitarian and some just the opposite, and none of them is better or worse than any of the others. They cannot be said to be equal either; they are simply not comparable in this language.
It is important to understand what this definition does not mean: it does not say that any efficient allocation is better, more desirable, than any inefficient one. Why not? Suppose you happen to gain from the inefficiency and I happen to lose. Then eliminating the inefficiency does not meet the test for a “better” state: you lose and I gain. ...
I have insisted on these gory--or dreary--details for a reason. Careful analysis shows that, if there are no distortions (and under further assumptions, to be discussed in a moment), a competitive market economy in equilibrium will achieve an efficient allocation of resources. ... Now comes the layer of ideology: advocates, some of whom may know better, use the “efficiency of free markets” to argue against taxes and regulation in general--they are distortions--and in favor of laissez-faire. Any interference with the free market, they declaim, is ipso facto a bad thing.
There are at least two things wrong with this ploy. The first has already been discussed. If a tax or regulation creates an inefficiency, “better” outcomes are available, but the pre-tax or pre-regulation situation is very unlikely to be among them. Some group will have gained from the regulation or from the tax and the use of its revenues. ... Perhaps I should be explicit also on the other side: many taxes and regulations create large inefficiencies for very little gain. The point is that no blanket statement is possible.
The second reason is that the Invisible Hand Theorem is valid only under certain assumptions, some of which only need to be stated to be seen as very dodgy. Clarifying those assumptions is the role of Cassidy’s “reality-based economics.” One of them is the absence of distorting taxes and regulations. Another is the absence of elements of monopoly, or monopolistic imperfections that fall well short of monopoly, like catchy brand names or advertising gimmicks that give a seller some freedom in setting prices, or other barriers to competition. Of course such imperfections are ubiquitous in every modern economy. The existence of economies of large-scale production in some industries is already a deal breaker for the Invisible Hand, and they make some element of monopoly essentially inevitable.
And that is far from the end of the matter. The informational requirements for the validity of the Invisible Hand Theorem are considerable..., and they must be willing and able to behave rationally in the light of it. ... Yet another requirement is the absence of significant external effects or “externalities.” ... Again, externalities are ubiquitous in a densely populated modern economy. ...
Faced with this list of obstacles, one might be tempted to give up on the market economy altogether. That would be as much of a mistake as the one made by doctrinaire free marketeers. The real point is that the choice is not either/or, but when and how much. Many distortions, imperfections, and externalities are small. To try to correct them all would be intolerably bureaucratic. The large ones cannot be wished away or ignored for reasons of piety; they cause large inefficiencies, and they can redistribute income in ways that most people would reject. And so there is no good alternative to case-by-case decision-making. ...
The market evangelists, who tend to claim more for unregulated markets than solid theory can justify, are ideologically motivated. They dislike and distrust governments so much that they overlook the exceptions and the implausible assumptions, and simply propose the blanket principle that the market knows best. What is improper in this manner of argument is the frequent casual hint that it is authorized by economic theory. Nothing so general is ever authorized by economic theory. ...

It makes interesting reading, but I wish he had asked himself an additional question. Why, in the marketplace of ideas, have the evangelists for the unrestricted market attracted so much attention and the “realists” so little? He argues, fairly convincingly, that the truth does not lie predominantly on that side of the issue. So is it that believers always make more effective advocates than skeptics do? Are we for some reason more receptive to simple answers than to complex ones? Is it that, in the nature of the case, there is more money backing one side than the other? Perhaps the long postwar prosperity provided good growing conditions for conservative political and economic ideology. If so, it will be interesting to see if the current recession and financial meltdown leave traces in the course of serious economics. ...

It could also be that those with the most wealth and power attribute their success to their own individual abilities. If so, then theories that attribute rewards, even at executive compensation levels, to the contributions the individual makes to society are naturally attractive, far more so than theories that say the success is due in any way to market imperfections or some other external factor.

[My take on the topic of market evangelism: Markets are not Magic.]

Sunday, January 03, 2010

"AD, AS, Y, Output Gaps, Cuba, Monopolistic Competition, and Recalculation"

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Nick Rowe has a nice explanation of why output in the U.S. is generally demand determined, and why this isn't necessarily true in all countries. See here.

Just one peripheral comment. Nick says that it took "half a century for monopolistic competition to make the transition to macro." That is true, for a long time perfect competition was assumed in these models for analytical convenience. But I've always thought that Keynes had monopolistically competitive markets in mind when he wrote the General Theory, and that this came about due to the influence of Joan Robinson (her theory of monopolistic competition appeared in 1933), something that was lost in the macroeconomics literature until the revival of these models in the early 1980s and their incorporation into the New Keynesian framework.

Monday, December 28, 2009

Google's Monopoly Power

It is not illegal to have monopoly power, but there are limits on how that power can be used. Has Google crossed over the line?:

Search, but You May Not Find. by Adam Raff, Commentary, NY Times: ...Today, search engines like Google, Yahoo and Microsoft’s new Bing have become the Internet’s gatekeepers, and the crucial role they play in directing users to Web sites means they are now as essential a component of its infrastructure as the physical network itself. The F.C.C. needs to look [at]... “search neutrality”: the principle that search engines should have no editorial policies other than that their results be comprehensive, impartial and based solely on relevance.
The need for search neutrality is particularly pressing because so much market power lies in the hands of one company: Google. With 71 percent of the United States search market (and 90 percent in Britain), Google’s dominance of both search and search advertising gives it overwhelming control. ...
One way that Google exploits this control is by imposing covert “penalties” that can strike legitimate and useful Web sites, removing them entirely from its search results or placing them so far down the rankings that they will in all likelihood never be found. For three years, my company’s vertical search and price-comparison site, Foundem, was effectively “disappeared” from the Internet in this way.
Another way that Google exploits its control is through preferential placement. With the introduction in 2007 of what it calls “universal search,” Google began promoting its own services at or near the top of its search results... Google now favors its own price-comparison results..., its own map results..., its own news results..., and its own YouTube results for video queries. And Google’s stated plans for universal search make it clear that this is only the beginning.
Because of its domination of the global search market and ability to penalize competitors while placing its own services at the top of its search results, Google has a virtually unassailable competitive advantage. And Google can deploy this advantage well beyond the confines of search to any service it chooses. Wherever it does so, incumbents are toppled, new entrants are suppressed and innovation is imperiled. ...
The preferential placement of Google Maps helped it unseat MapQuest from its position as America’s leading online mapping service virtually overnight. ... Without search neutrality rules to constrain Google’s competitive advantage, we may be heading toward a bleakly uniform world of Google Everything — Google Travel, Google Finance, Google Insurance, Google Real Estate, Google Telecoms and, of course, Google Books.
Some will argue that Google is itself so innovative that we needn’t worry. But the company isn’t as innovative as it is regularly given credit for. Google Maps, Google Earth, Google Groups, Google Docs, Google Analytics, Android and many other Google products are all based on technology that Google has acquired rather than invented. Even AdWords and AdSense ... are essentially borrowed inventions...
Google ... now faces a difficult choice. Will it embrace search neutrality...? Or will it try to argue that discriminatory market power is somehow ... harmless in the hands of an overwhelmingly dominant search engine? ...

Thursday, December 17, 2009

FTC Files Antitrust Suit against Intel

Maybe I was wrong when I said that the administration is all talk and no action when it comes to reining in market power. Hope so:

F.T.C. Accuses Intel of Trying to Stifle Competition, by Steve Lohr, NY Times

Monday, December 14, 2009

Too Big to File Suit?

I've been somewhat encouraged by this administration's attention to anti-trust issues, but so far there's been more talk than action. I don't think this issue received enough attention in the previous administration -- if anything the Bush administration promoted the interests of large, powerful firms -- and the movement away from strict enforcement of anti-trust rules can be traced to Ronald Reagan's push against government intervention in markets. There have been a few headline cases, e.g. Microsoft, but not the kind of systematic examination of markets and the enforcement of rules to promote competition as I'd like to see. I've been hoping this administration would change that.

Maybe there's a reason for the lack of action. One cost of a severe recession is that anti-trust enforcement is likely to be pursued with less vigor. Suppose, for example, that the government is considering initiating an anti-trust suit against a few large, systemically important firms within the economy (e.g. Google and Wal-Mart? Goldman Sachs?). The government might worry that doing so would create uncertainty in these businesses and cause them to pull back on expansion plans, be less aggressive, etc. That could make already bad conditions even worse, and it could also create uncertainty more broadly within the business community and cause similar, amplifying effects. Thus, the government might prefer to withhold action until things got better (much as though it might be willing to let a car company fail during good times, but not in a recession).

Even if the initiation and pursuit of such action has no effect at all on economic activity, the recovery from the recession could drag on for awhile, and the sluggish recovery could be attributed, in part, to the government's action. Thus, initiating an anti-trust suit against a large, economically important firm would leave the party in power vulnerable to a charge from the other side that their "overly zealous" enforcement of these laws prolonged the recession. As a political calculation, why not wait until things improve before taking such potentially politically volatile action?

There may be other reasons to wait as well. e.g. needing votes to pass a stimulus package that might be lost if anti-trust action is announced. So it seems quite likely that an administration might decide to delay action until the economy is on more solid footing rather than taking action that might upset the economy or leave them politically vulnerable to charges of making conditions worse. It could also be that these types of cases are complicated and take time to build, and with no foundation from the previous administration to build upon, it's too soon to expect results.

But I also worry that, for whatever reason, the administration won't actually take the needed action even when things get better and they've had plenty of time to build their case. One argument used in the past to forestall the regulation of market power is the argument that markets are self-regulating, that they can take care of market power problems by themselves (and it's best to let them do so). We've seen how well the self-regulation argument works when it's applied to financial markets, and it doesn't work any better when it comes to market power. Regulation and effective enforcement of the rules are needed to solve the problem.

It's costly when one or a few firms dominate markets, and it's not just the economic losses that are the problem. Excessive size also gives firms political power and influence and this, too, is costly. We should have done something about this long ago -- perhaps more attention to the costs associated with excessive size and power would have left us less tolerant of too big to fail firms in the financial sector. But in any case, I hope the administration follows up on its increased scrutiny of market power and anti-competitive behavior with meaningful action. We shall see.

Monday, December 07, 2009

Stiglitz: Too Big to Live

When Ben Bernanke was asked about the "too big to fail" problem not too long ago, the WSJ Economics blog reports:

Federal Reserve Chairman Ben Bernanke voiced skepticism that breaking-up big banks is the way to solve the so-called too big to fail problem...

Asked for his thoughts on Bank of England Gov. Mervyn King’s recent speech that advocated breaking up banks that were so large that their failure would represent a risk to the broader financial system, Bernanke said that making banks smaller would not necessarily be the solution to the problem. Smaller banks can also play important roles in financial systems, he said. He noted that during the 1930s, the U.S. didn’t have too many large bank failures, but the country suffered thousands of failures of smaller banks that added to the woes of the Great Depression. “I don’t think simply making banks smaller is the way to do it,” he said.

Still, more than once during his comments to the Economic Club of New York, Bernanke emphasized that it is crucial that large financial firms be allowed to fail in order to return market discipline to the financial system.

It is not at all clear to me that breaking large banks into smaller pieces addresses the connectedness issue. Smaller banks can be just as interconnected as larger banks, and hence simply breaking banks up without examining the effect it has on the underlying financial network connections may not reduce systemic risk.

Joseph Stiglitz says break them up whenever possible, regulate them heavily when it's not possible:

Too Big to Live, by Joseph E. Stiglitz, Commentary, Project Syndicate: A global controversy is raging... Mervyn King, the governor of the Bank of England, has called for restrictions on the kinds of activities in which mega-banks can engage. ... King is right to demand that banks that are too big to fail be reined in. In the United States, the United Kingdom, and elsewhere, large banks have been responsible for the bulk of the cost to taxpayers. ...
The crisis is a result of at least eight distinct but related failures:
  • Too-big-to-fail banks have perverse incentives; if they gamble and win, they walk off with the proceeds; if they fail, taxpayers pick up the tab.
  • Financial institutions are too intertwined to fail...
  • Even if individual banks are small, if they engage in correlated behavior – using the same models – their behavior can fuel systemic risk;
  • Incentive structures within banks are designed to encourage short-sighted behavior and excessive risk taking.
  • In assessing their own risk, banks do not look at the externalities that they (or their failure) would impose on others, which is one reason why we need regulation in the first place.
  • · Banks have done a bad job in risk assessment – the models they were using were deeply flawed.
  • · Investors, seemingly even less informed about the risk of excessive leverage than banks, put enormous pressure on banks to undertake excessive risk.
  • · Regulators, who are supposed to understand all of this and prevent actions that spur systemic risk, failed. They, too, used flawed models and had flawed incentives; too many didn’t understand the role of regulation; and too many became “captured” by those they were supposed to be regulating.
... There are, of course, costs to regulations, but the costs of having an inadequate regulatory structure are enormous. We have not done nearly enough to prevent another crisis... King is right: banks that are too big to fail are too big to exist. If they continue to exist, they must exist in what is sometimes called a “utility” model, meaning that they are heavily regulated.

In particular, allowing such banks to continue engaging in proprietary trading distorts financial markets. Why should they be allowed to gamble, with taxpayers underwriting their losses? What are the “synergies”? Can they possibly outweigh the costs? Some large banks are now involved in a sufficiently large share of trading ... that they have, in effect, gained the same unfair advantage that any inside trader has.

This may generate higher profits for them, but at the expense of others. It is a skewed playing field – and one increasingly skewed against smaller players. Who wouldn’t prefer a credit default swap underwritten by the US or UK government; no wonder that too-big-to-fail institutions dominate this market.

The one thing nowadays that economists agree upon is that incentives matter. ... Given the lack of understanding of risk by investors, and deficiencies in corporate governance, bankers had an incentive not to design good incentive structures. It is vital to correct such flaws – at the level of the organization and of the individual manager.

That means breaking up too-important-to fail (or too-complex-to-fix) institutions. Where this is not possible, it means stringently restricting what they can do and imposing higher taxes and capital-adequacy requirements, thereby helping level the playing field. ...

Even if we fix bank incentive structures perfectly ... the banks will still represent a big risk. The bigger the bank, and the more risk-taking in which big banks are allowed to engage, the greater the threat to our economies and our societies. ... What is required is a multi-prong approach, including special taxes, increased capital requirements, tighter supervision, and limits on size and risk-taking activities.

Such an approach won’t prevent another crisis, but it would make one less likely – and less costly if it did occur.

I think limiting connectedness and limiting leverage ratios are both essential elements of reform. There will always be vulnerabilities, even in a system that has only small financial institutions, and we may not be able to identify the vulnerabilities in time. Shocks are going to happen. Limiting connectedness and leverage ratios for both big and small firms (along with regulation on what types of activities they can engage in, which addresses an aspect of connectedness) will reduce the magnitude of the damage to the financial system and the broader economy that those inevitable shocks are able to bring about.

Sunday, December 06, 2009

Did Bank Executives Lose Enough to Learn their Lesson?

Will the losses that financial executives suffered as a result of the crisis provide the discipline necessary to prevent excessive risk taking in the future? Not according to this analysis:

Bankers had cashed in before the music stopped, by Lucian Bebchuk, Alma Cohen, and Holger Spamann, Commentary, Financial Times: According to the standard narrative, the meltdown of Bear Stearns and Lehman Brothers largely wiped out the wealth of their top executives. Many – in the media, academia and the financial sector – have used this account to dismiss the view that pay structures caused excessive risk-taking and that reforming such structures is important. That standard narrative, however, turns out to be incorrect.
It is true that the top executives at both banks suffered significant losses on shares they held when their companies collapsed. But our analysis ... shows the banks’ top five executives had cashed out such large amounts since the beginning of this decade that, even after the losses, their net pay-offs during this period were substantially positive. ...
Our analysis undermines the claims that executives’ losses on shares during the collapses establish that they did not have incentives to take excessive risks. ...[R]epeatedly cashing in large amounts of performance-based compensation based on short-term results did provide perverse incentives – incentives to improve short-term results even at the cost of an excessive rise in the risk of large losses at some (uncertain) point in the future.
To be sure, executives’ risk-taking might have been driven by a failure to recognise risks or by excessive optimism, and thus would have taken place even in the absence of these incentives. But given the structure of executive pay, the possibility that risk-taking was influenced by these incentives should be taken seriously.

The need to reform pay structures is not, as many have claimed, simply a politically convenient sideshow. ... To understand what has happened, and what lessons should be drawn, it is important to get the facts right. In contrast to what has been thus far largely assumed, the executives were richly rewarded for, not financially devastated by, their leadership of their banks during this decade.

It doesn't really matter whether executive compensation structures caused or contributed to the crisis or not. If the manner in which executives are paid creates perverse incentives and distorts decisions away from the best interests of shareholders, as it appears to do, then both the level and structure of the compensation should be fixed.

Tuesday, November 10, 2009

"Powerful Interests are Trying to Control the Market"

For the first few years I was doing this, I'd often complain that government regulators weren't doing enough to intervene in cases where firms had substantial market power. But this was mainly an economic worry about how market power leads to the inefficient utilization of resources. Over time, however, I've started to worry more and more about the harm that comes when large firms have the ability to exert undue influence on the political process (see health care, financial, or greenhouse gas emission reform just for starters). So I agree with this call to limit rent-seeking activities:

Powerful interests are trying to control the market, by John Kay, Commentary, Financial times: ...Control of rent-seeking requires decentralisation of economic power. These policies involve limits on the economic role of the state; constraints on the concentration of economic power in large business; constant vigilance at the boundaries between government and industry; and a mixture of external supervision and internal norms to limit the capacity of greedy individuals in large organisations to grab corporate rents for themselves. Vigorous pursuit of these is the difference between a competitive market economy and a laisser-faire regime, and it is a large difference. ...
[T]he scale of corporate rent-seeking activities by business and personal rent-seeking by senior individuals in business and finance has increased sharply.
The outcomes can be seen in the growth of Capitol Hill lobbying and the crowded restaurants of Brussels; in the structure of industries such as pharmaceuticals, media, defence equipment and, of course, financial services; and in the explosion of executive remuneration.
Because innovation is dependent on new entry it is essential to resist concentration of economic power. A stance which is pro-business must be distinguished from a stance which is pro-market. In the two decades since the fall of the Berlin Wall, that distinction has not been appreciated well enough. ... The essence of a free market economy is not that the government does not control it. It is that nobody does.

On government's role in the economy, this is from a previous post:

Free markets - where free simply means minimal government involvement - are not necessarily the same as competitive markets. There is nothing that says what many interpret as freeing markets - lifting all government restrictions - will give us competitive markets, not at all. Government regulation (as well as laws, social norms, etc.) is often necessary to help markets approach competitive ideals. Environmental restrictions that force producers to internalize all costs of production make markets work better, not worse. Rules that require full disclosure, or that impose accounting standards help to prevent asymmetric information improve market outcomes. Breaking up firms that are too large prevents exploitation of monopoly power (or prevents them from becoming "too large to fail") which can distort resource flows and distort the distribution of income. Making sure that labor negotiations between workers and firms are on an equal footing doesn't move markets away from an optimal outcome, just the opposite, it helps to move us toward the efficient, competitive ideal, and it helps to ensure that labor is rewarded according to its productivity (unlike in recent years where real wages have lagged behind). There is example after example where government involvement of some sort helps to ensure markets work better by making sure they are as competitive as possible.

Thursday, November 05, 2009

Wal-Mart versus Amazon?

James Surowiecki looks at the latest price war:

Priced to Go, by James Surowiecki: In the spring of 1992, the airline industry ... found itself in the middle of a full-fledged price war. In a matter of months, the airlines collectively lost four billion dollars. ...[A]t bottom it was just like other price wars: all the companies involved got hurt.

So you might wonder why Wal-Mart recently decided to start its own price war, taking on Amazon in the online book market. ...Amazon and Wal-Mart are surely losing money every time they sell one of the discounted titles. The more they sell, the less they make. That doesn’t sound like good business.

It’s easy to see how price wars get started. In industries where a lot of competitors are selling the same product—mangoes, gasoline, DVD players—price is the easiest way to distinguish yourself. The hope is that if you cut prices enough you can increase your market share, and ... your profits. But this works only if your competitors won’t, or can’t, follow suit. More likely, they’ll cut prices, too, and you’ll end up selling the same share of mangoes, only at a lower price...: everyone loses. ...
The best way to win a price war, then, is not to play in the first place. Instead, you can compete in other areas: customer service or quality. Or you can collude...—since overt collusion is usually illegal—you can employ subtler tactics ... like making public statements about the importance of “stable pricing.” The idea is to let your competitors know that you’re not eager to slash prices—but that, if a price war does start, you’ll fight to the bitter end. One way to establish that peace-preserving threat of mutual assured destruction is to commit yourself beforehand, which helps explain why so many retailers promise to match any competitor’s advertised price. Consumers view these guarantees as conducive to lower prices. But ... offering a price-matching guarantee should make it less likely that competitors will slash prices, since they know that any cuts they make will immediately be matched. It’s the retail version of the doomsday machine.
These tactics and deterrents don’t always work, though, which is why price wars keep breaking out. Sometimes it’s rational: when a company is genuinely more efficient than its competitors, lowering prices is usually a smart move. (That’s how competition is supposed to work.) More often, price wars are reckless gambles. ...
Amazon and Wal-Mart hardly seem reckless, though. So why did they go to war? The answer is that they didn’t, really. Sure, Wal-Mart is making a statement that it’s a player in the online world, but the real goal of this conflict isn’t to lure readers away from Amazon... It’s to lure them online, away from big booksellers and other retailers, and then sell them other stuff... It’s textbook loss-leader economics. ...

The real competition in this price war is not between Wal-Mart and Amazon but between those behemoths and everyone else—and the damage everyone else is incurring is deliberate, not collateral. Wal-Mart and Amazon have figured out how to fight a price war and win: make sure someone else takes the blows.

[Traveling: Preset to post automatically.]

One more time, is CEO pay justified?:

Banker Bonus Rain, by Nancy Folbre, Economix: ...Wall Street firms have always been famous for their generous bonuses to managers and traders — their so-called “rainmakers.” The graph ... shows that employee bonuses have actually exceeded the estimated pre-tax profits of United States securities dealers in many years. What is especially striking is the high level of these bonuses in 2007 and 2008, years in which profits were negative. ...
Much of the justification offered for current pay caps in the United States rests on indignation about government bailouts. As long as companies are not subsidized by taxpayer money, perhaps market forces should be allowed to determine pay.
But do market forces determine pay the way most economists assume? Many arguments to the contrary are effectively mobilized by the University of Massachusetts economist James Crotty in a recent working paper.
Top executives of financial firms often choose the very board members who are expected to monitor their pay decisions.
Investment banking is a demanding job. “Rainmakers” typically work long hours under high stress. Yet the number of highly qualified graduates from top colleges eager to enter investment banking has typically far exceeded the demand. Why hasn’t the excess of supply over demand failed to drive earnings down?
The importance of personal networks and contacts gives rainmakers leverage. As the Nobel laureate Oliver Williamson emphasizes, the threat of withdrawing from or disrupting productive relationships can give employees considerable power. The apprenticeship structure of the job gives senior managers and traders control over their successors.
The very qualities that contribute to success on the trading floor — including aggressive use of technical expertise — may be deployed in joint efforts to reduce competition from new job entrants...
In any case, highly paid employees in finance earn large premiums compared to their counterparts in other industries — pay differences that persist even when virtually all measurable differences in individual characteristics are taken into account. ...
Deregulation made it easier for rainmakers to conceal risks that short-term profits would morph into long-run losses. The oligopolistic structure of the industry — now more concentrated than ever as a result of bank failures and mergers — made it easier for them to collude.
Financial firms are investing heavily in lobbying to block efforts to make the industry more competitive. Their rainmakers are still pretty good at making rain for one another.

The article doesn't directly answer the question "is CEO pay justified?," but I will. No it isn't, and the way the pay is structured has led to bad incentives within these firms that contributed to our current problems (too much emphasis on short-term profits at the expense of what is best for stockholders in the long-run). There are still a few apologists -- those who argue that CEO pay is justified by their high productivity, i.e. by what they add to the firm, but their numbers are dwindling.

[Traveling: Preset to post automatically.]

Friday, October 23, 2009

"Bernanke: Smaller Banks Not Necessarily the Answer"

Ben Bernanke does not want to lose "the economic benefit of multi-function, international (financial) firms," so he is hesitant to break large banks into smaller sized institutions. I don't have much problem with the economics, if there are efficiencies that come with bank size we should exploit them, especially if breaking up banks into smaller entities does little to reduce systemic risk but instead simply fragments the problem into many more pieces (though I'd still like to know where the minimum efficient scale is, anything larger than that is unnecessary). Obtaining resolution authority for banks in the shadow system is also very important, so I don't disagree with the emphasis on this in Bernanke's remarks.

But there seems to be the view that if they have resolution authority, higher capital requirements, etc., that will make the probability of a major breakdown small enough so that the expected benefits of size outweigh the expected costs. While I agree that obtaining resolution authority and other regulatory change is extremely important, I wouldn't bet my house, or housing and asset markets more generally, that this will eliminate the chance of a major breakdown, or make the chance small enough to justify huge, powerful, market-dominating institutions.

I would like to see more effort to measure and regulate connectedness within the system (which can be very high even with banks broken into smaller pieces) since that would add another layer of protection, the degree of leverage should come under scrutiny as well, and I would also like to see more attention to the political risks (e.g. capture of legislators and hence regulation) posed by large financial firms:

Bernanke: Smaller Banks Not Necessarily the Answer for ‘Too Big to Fail’ Dilemma, by David Wessel, WSJ: Mervyn King, governor of the Bank of England, says the solution to banks that are “too big to fail” is to have smaller banks. But Ben Bernanke, chairman of the U.S. Federal Reserve, says he isn’t convinced that’s the best answer.
Mr. Bernanke ... said he would prefer “a more subtle approach without losing the economic benefit of multi-function, international (financial) firms.” ...
Mr. Bernanke suggested alternatives such as higher capital requirements against bank trading books, higher capital for “systemically important” institutions and a congressionally created process for coping with failing big financial firms in ways other than bankruptcy or bail out.
He also expressed interest in what have been dubbed “living wills” — plans that big banks would have to maintain for winding down their operations.
The goal, Mr. Bernanke said, is to reduce “the artificial incentives for size” — including the incentive to grow large so that government bailouts are anticipated — so that financial firms instead grow to a size that is economically valuable in a global economy populated by large multinational companies.
The Fed chairman did emphasize that supervisors should have the authority and willingness to tell the management of a large institution, where appropriate, that it cannot expand unless it improves its management and risk-management capabilities.
Both in answering the question and in his prepared text, Mr. Bernanke again beseeched Congress to act soon to give regulators “resolution authority” to cope with the imminent collapse of a big financial firm other than a bank, and to address other vulnerabilities in the regulatory regime exposed during the crisis.

Monday, October 19, 2009

"How Moody's Sold its Ratings -- and Sold Out Investors"

Robert Waldmann says "This McClatchy article by Kevin G Hall seems important to me." It does seem like there was "market failure in everything" when it comes to mortgage markets, from the incentives faced by the homeowner (non-recourse loans) and real estate agent ( maximize commission income) at the very first point of contact, through other points in the system such as appraisers, mortgage brokers, and bank managers.

Maybe fixing the incentive problems at each of these steps would have stopped the problem, or at least made it much less severe, but maybe not. In any case, it's clear that markets failed to self regulate at many key points, and that there are problems that need to be fixed covering the entire spectrum from the sale of higher priced, higher profit mortgage contracts to unwary homeowners when better options were available to the incentives bank managers had to maximize short-run profits and accumulate too much risk.

But the flow of toxic paper upward through the system should have had a gatekeeper of last resort, or at least a thorough checkpoint, and that was the ratings agencies. I don't think the failure of the ratings agencies, by itself, caused the financial crisis, but it was an important contributor and it's one of the things that needs to be fixed:

How Moody's sold its ratings -- and sold out investors, by Kevin G. Hall, McClatchy Newspapers: As the housing market collapsed in late 2007, Moody's Investors Service, whose investment ratings were widely trusted, responded by purging analysts and executives who warned of trouble and promoting those who helped Wall Street plunge the country into its worst financial crisis since the Great Depression.
A McClatchy investigation has found that Moody's punished executives who questioned why the company was risking its reputation by putting its profits ahead of providing trustworthy ratings for investment offerings.
Instead, Moody's promoted executives who headed its "structured finance" division, which assisted Wall Street in packaging loans into securities for sale to investors. It also stacked its compliance department with the people who awarded the highest ratings to pools of mortgages that soon were downgraded to junk. Such products have another name now: "toxic assets."
As Congress tackles the broadest proposed overhaul of financial regulation since the 1930s, however, lawmakers still aren't fully aware of what went wrong at the bond rating agencies, and so they may fail to address misaligned incentives...
The Securities and Exchange Commission issued a blistering report on how profit motives had undermined the integrity of ratings at Moody's and its main competitors, Fitch Ratings and Standard & Poor's,... but the full extent of Moody's internal strife never has been publicly revealed.
Moody's ... disputes every allegation against it. "Moody's has rigorous standards in place to protect the integrity of ratings from commercial considerations," said Michael Adler, Moody's vice president for corporate communications... Insiders, however, say that wasn't true before the financial meltdown.
To promote competition, in the 1970s ratings agencies were allowed to switch from having investors pay for ratings to having the issuers of debt pay for them. That led the ratings agencies to compete for business by currying favor with investment banks that would pay handsomely for the ratings they wanted.
Wall Street paid as much as $1 million for some ratings, and ratings agency profits soared. This new revenue stream swamped earnings from ordinary ratings. ... Ratings agencies thrived on the profits that came from giving the investment banks what they wanted, and investors worldwide gorged themselves on bonds backed by U.S. car loans, credit card debt, student loans and, especially, mortgages. ...
Nobody cared about due diligence so long as the money kept pouring in during the housing boom. ...
One Moody's executive who soared through the ranks during the boom years was Brian Clarkson, the guru of structured finance. He was promoted to company president just as the bottom fell out of the housing market. Several former Moody's executives said he made subordinates fear they'd be fired if they didn't issue ratings that matched competitors' and helped preserve Moody's market share. ...
Clarkson rose to the top in August 2007, just as the subprime crisis was claiming its first victims. Soon afterward, a number of analysts and compliance officials who'd raised concerns about the soundness of the ratings process were purged and replaced with people from structured finance. ...
Another mid-level Moody's executive ... recalls being horrified by the purge. "It is just something unthinkable, putting business people in the compliance department. It's not acceptable. I was very upset, frustrated," the executive said. "I think they corrupted the compliance department." ...
Others who worked at Moody's at the time described a culture of willful ignorance in which executives knew how far lending standards had fallen and that they were giving top ratings to risky products.
"I could see it coming at the tail end of 2006, but it was too late. You knew it was just insane," said one former Moody's manager. "They certainly weren't going to do anything to mess with the revenue machine." ...[...more...]...

Wednesday, October 14, 2009

"Transaction Cost Economics"

Why do firms exist? Why is it sometimes beneficial to, say, produce a part needed in the production process yourself, and why is it better to contract with an outside firm at other times? Where are the boundaries between what will be performed internally, and what will be performed externally? How should firms be organized? Robert Salomon explains the contributions of Oliver Williamson to the field of Transaction Cost Economics, and he reacts to some of the reactions to the announcement of the award:

Oliver Williamson, Nobel Honoree, by Robert Salomon: I was delighted to hear that Oliver Williamson was awarded the Nobel Prize in Economics (shared with Elinor Ostrom). Oliver Williamson is recognized for his contribution to the field of Transaction Cost Economics, building on the path-breaking work of scholars like Ronald Coase.
Transaction Cost Economics is a central theory in the field of Strategy. It addresses questions about why firms exist in the first place (i.e., to minimize transaction costs), how firms define their boundaries, and how they ought to govern operations.
In Transaction Cost Economics, the starting point is the individual transaction (the synapse between the buyer and the seller). The question then becomes: Why are some transactions performed within firms rather than in the market, as the neoclassical view prescribes.
The answer, not surprisingly, is because markets break down.
As a consequence of human cognitive limitations, coupled with the costs associated with transacting, the basic assumptions associated with efficient markets (e.g., anonymous actors, atomistic actors, rational actors, perfect information, homogeneous goods, the absence of liquidity constraints) fail to hold. For these reasons it is often more advantageous to structure transactions within firms. And this is why firms are not just ubiquitous in our society, but also worthy of study in their own right. This contrasts with the typical view of firms in neoclassical economic theory as, at worst, a market aberration that ought not exist, and at best, a black box production function.
Williamson’s contributions to the field of Transaction Cost Economics complement, and extend, those of Coase. First, Williamson started with an explicitly behavioral assumption of human behavior (bounded rationality). Second, he recognized that transacting parties sometimes behave opportunistically and take advantage of their counterparties. Finally, he identified features of transactions (e.g., specificity, uncertainty, frequency) that cause markets to fail; and hence, are likely to lead certain transactions to be organized within firms (hierarchies) rather than markets.
I was pleased to see Oliver Williamson recognized not just because of my inherent intellectual bias — my research has drawn on, and contributed to, the field of Transaction Cost Economics and I have worked with students of Williamson (see my research page for details) — but also because of what his selection implies for the broader field of economics. It implies that the field is moving in the direction of greater inclusion of economic perspectives that are based more on behavioral theories (see Krugman on the Future of Economics).
It was also fun to watch establishment economists make sense of the selection (see the Economists View post for some perspective). For example, Steven Leavitt writes:
When I was a graduate student at MIT back in the early 1990’s, there was a Nobel Prize betting pool every year. Three years in a row, Oliver Williamson was my choice. At the time, his research was viewed as a hip, iconoclastic contribution to economics — something that was talked about by economists, but that students were not actually trying to emulate (and probably would have been actively discouraged from had they tried to do so). What’s interesting is that in the ensuing 15 years, it seems to me that economists have talked less and less about Williamson’s research, at least in the circles in which I run.
My comment: I think Leavitt underestimates the impact of Williamson’s work because he is neither a Strategy scholar, nor is he in a Strategy or Management department. Go to any Strategy or Management department and you will find oodles of researchers (and doctoral students) working on Transaction Cost problems. It is a dominant paradigm.
Paul Krugman (in his post An Institutional Economics Prize) writes:
The way to think about this prize is that it’s an award for institutional economics, or maybe more specifically New Institutional Economics.
Neoclassical economics basically assumes that the units of economic decision-making are a given, and focuses on how they interact in markets. It’s not much good at explaining the creation of these units — at explaining, in particular, why some activities are carried out by large corporations, while others aren’t. That’s obviously an interesting question, and in many cases an important one.
…Oliver Williamson’s work underlies a tremendous amount of modern economic thinking; I know it because of the attempts to model multinational corporations, almost all of which rely to some degree on his ideas.
My comment: Krugman gets it partially right, but he does a lot of handwaving with respect to Williamson’s specific contributions. But with all due respect, he certainly makes no claim to be a Strategy scholar. He is right in the sense that the award speaks volumes about New Institutional Economics, broadly defined. However, in the case of Williamson, the specific contribution is to the field of Transaction Cost Economics. Moreover, the contributions of Williamson’s work extend far beyond the field of international business (or international strategy), but I agree that Transaction Cost Economics has been influential in those fields as well.
Nevertheless, my congratulations to Oliver Williamson, and to his students (many of whom I know well), who have long carried the torch for this important, yet underappreciated, branch of economics.

Friday, October 09, 2009

"Skewed Rewards for Bankers"

Joseph Stiglitz remembers another Nobel:

Skewed rewards for bankers, Joseph Stiglitz, Project Syndicate:  -- The recent death of Norman Borlaug provides an opportune moment to reflect on basic values and on our economic system. Borlaug received the Nobel Peace Prize for his work in bringing about the "green revolution," which saved hundreds of millions from hunger and changed the global economic landscape. ...

Continue reading ""Skewed Rewards for Bankers"" »

Friday, October 02, 2009

Do Regulators Have Distorted Incentives?: Beatrice Weder di Mauro Roundtable at Free Exchange

I'm participating in a roundtable discussion at Free Exchange. The lead article by Beatrice Weder di Mauro argues that regulators need better incentives:

Here's my response:

Here are other responses:

Monday, September 28, 2009

Stiglitz Interview

James Surowiecki interviews Joseph Stiglitz about "the mishandling of the financial crisis, the relationship between government and markets, and the future of capitalism around the world."

Friday, September 18, 2009

"Regulating for an Independent Media"

This research says that advertising has "seriously interfered with the quality, accuracy, and breadth of content and programming in the media." The proposed solution is to ensure that there is "vigorous competition in media markets," and to provide "public funding of informative media as a public good":

Regulating for an independent media: The problems of political and commercial bias, by Matthew Ellman and Fabrizio Germano, Vox EU: There is a crisis in media and journalism, and policymakers have to tackle both political and commercial influence in the media.

Continue reading ""Regulating for an Independent Media"" »

Thursday, September 10, 2009

Solving the Free Rider Problem using fMRI Measurements

If we hook up a randomly chosen set of people to magnetic neural imaging machines to see if they are truthfully revealing their valuation of public goods, we can improve our ability to provide these services, but the intrusiveness of the solution seems problematic, at least to me. Does this bother you, or does it seem like a good idea to move in this direction? [Update: Cheap Talk has good comments on the research]:

Caltech scientists develop novel use of neurotechnology to solve classic social problem, EurekAlert: Economists and neuroscientists from the California Institute of Technology (Caltech) have shown that they can use information obtained through functional magnetic resonance imaging (fMRI) measurements of whole-brain activity to create feasible, efficient, and fair solutions to one of the stickiest dilemmas in economics, the public goods free-rider problem—long thought to be unsolvable.
This is one of the first-ever applications of neurotechnology to real-life economic problems, the researchers note. "We have shown that by applying tools from neuroscience to the public-goods problem, we can get solutions that are significantly better than those that can be obtained without brain data," says Antonio Rangel, associate professor of economics at Caltech and the paper's principal investigator.
The paper describing their work was published today in the online edition of the journal Science, called Science Express.
Examples of public goods range from healthcare, education, and national defense to the weight room or heated pool that your condominium board decides to purchase. But how does the government or your condo board decide which public goods to spend its limited resources on? And how do these powers decide the best way to share the costs?

Continue reading "Solving the Free Rider Problem using fMRI Measurements" »

Wednesday, September 02, 2009

A Financial Transactions Tax?

Is a Tobin tax on financial transactions just what the deficit and efficiency doctors ordered? Dean Baker has been advocating for a financial transactions tax, and here's his explanation for why it is needed:

A Financial Transactions Tax, by Dean Baker, Commentary, Counterpunch: Just like that perfect sweater, a financial transactions tax (FTT) would look just great on those Wall Street bankers and financiers. A modest tax, which would be too small for normal investors to even notice, could easily raise more than $100 billion a year. ...
[A]n FTT makes a huge amount of sense. The basic point is quite simple. A tax of 0.25 percent on the sale or purchase of a share of stock will make little difference to a person who intends to hold the share for 5-10 years as a long-term investment. ... A small increase in trading costs would be a very manageable burden for those who are using financial markets to support productive economic activity. However, it would impose serious costs on those who see the financial markets as a casino in which they place their bets by the day, hour, or minute. Speculators who hope to jump into the market at 2:00 and pocket their gains by 3:00 would be subject to much greater risk if they had to pay even a modest financial transaction tax. ...
The Wall Streeters and their flacks will insist that an FTT is unenforceable and will simply result in trading moving overseas. There is a small problem with this argument call the “United Kingdom.” The U.K. has had a tax on stock trades ... for decades. The revenue raised each year would be equivalent to $30 billion in the U.S. economy. Obviously, the tax is enforceable.
In fact, we can go beyond the U.K. and add other measures to make enforcement more fun. For example, we can give workers an incentive to turn in their cheating bosses by awarding them 10 percent of any revenue and penalties that the government collects. ...
Of course, the prospect of the financial industry moving overseas should not be troubling any case. Why should we be any more bothered by buying our financial services from foreigners than by buying our steel from foreigners? If the industry moved overseas, then it could corrupt some other country’s politics.
The basic point is simple. A FTT can allow us to raise more than $100 billion annually to finance health care or any other budget item that we consider important. It does so in a way that is very progressive and will weaken the financial industry both economically and politically. In fact, even Larry Summers, the head of President Obama’s National Economic Council, even argued that a FTT was a good idea. ...

Here's a bit more on the tax, whether the Obama administration might support it, and Summer's support of the tax in the past:

A Tobin tax for Wall Street?, by Robert Kuttner, Prospect: Now that Adair Turner has opened the door to a forbidden subject—Tobin taxes on financial transactions—could the Obama administration embrace such an idea?
Professor Tobin first proposed his tax to address currency speculation. This was in 1972, when the fixed-rate regime of Bretton Woods had collapsed. His concern was that speculative trades were fundamentally distorting currency values and damaging the real economy. The tax that he proposed was intended to damp down the volatility in currency movements, and take much of the profit out of purely speculative, short-term moves.
The early 1970s was a period ... before the general financial deregulation that followed. Since that time, speculative trading has distorted not just currency markets, but the broad financial market itself. The volume of short-term trades has grown far faster than the value of the stock market or the real economy. The most recent case in point is ultra high-speed computerised trading...
A small tax on very short-term financial transactions would have two immense benefits. It would discourage purely speculative trades, while having no significant effects on long-term investments, and it would thus help restore the legitimate function of financial markets: connecting investors to entrepreneurs. Secondly, it could raise a substantial amount of revenue in a highly progressive fashion—at a time when large deficits loom.
The Obama administration might take a serious look at a Tobin tax for both of these reasons. Early in his career, Larry Summers, Obama’s economic policy chief, was a supporter of the Tobin tax. In a 1989 paper, co-authored with his former wife, Victoria Summers, he wrote that there might be times when it was salutary to throw a little sand in the gears of trading markets. The paper was titled: “When Financial Markets Work too Well: a Cautious Case for a Securities Transaction Tax.”
However, the Obama administration’s regulatory stance is still a long distance away from taking serious measures to discourage speculative trading markets as a general policy goal. The more likely motivation would be concerns about the federal budget deficit. ...
The tax, of course, would be fiercely resisted by Wall Street. For a reform administration, Obama’s government has approached any confrontation with Wall Street very gingerly. ... Even if Obama comes to a Tobin tax via the back door of revenue needs, this would be most welcome, as it would also lead to examination a larger, neglected issue: how to rein in financial engineering for the good of the larger economy.

Since I don't have a strong opinion on this, let's play "he said-he said." Here's Willem Buiter with an alternative view:

Forget Tobin tax: there is a better way to curb finance, by Willem Buiter, Commentary, Financial Times: Lord Turner, chairman of the UK’s Financial Services Authority, has set the cat among the financial pigeons by making highly critical comments about ... financial intermediation... He recommended some drastic remedies, and suggested considering a global tax on financial transactions – a generalised Tobin tax. ...
What problem would a Tobin tax on financial transactions solve? Lord Turner asserts ... that the UK financial sector has grown too big; that some financial sector activity is worthless from a social perspective; that the sector is destabilising...; and that new taxes may be required to curb excessive profits and pay in the sector. ... Even if all these assertions are correct, they do not imply the need for a Tobin tax.
Economics teaches us that taxes and other public interventions to correct distortions and other market failures should be targeted directly at the distortion or failure in question. What distortion is a tax on financial transactions targeted at?
The financial sector is too big throughout the overdeveloped world in part because much of it enjoys a free state guarantee against default on its unsecured debt. ... The cost of capital to the banking sector is subsidised, causing the sector to be too large.
The solution is clear, and it is not a tax on financial transactions: bring default risk back into the calculations of unsecured creditors and other counterparties of the financial sector. This would eliminate the capital subsidy to the industry. The obvious way to do this is through the creation of a “special resolution regime” as an alternative to bankruptcy for all systemically important financial institutions. This would permit their unsecured creditors and other counterparties to be forcibly and swiftly converted into shareholders, until the institutions are adequately capitalised. It must be possible to achieve such a mandatory recapitalisation by unsecured creditors and counterparties for any institution overnight, and without interrupting normal business. A regularly updated “will” for each systemically important financial institution would eliminate any remaining “too big, too interconnected, too complex and too international to fail” obstacles to the Darwinian discipline of the market, which has been sorely missed in the financial sector.
I believe that efficient financial intermediation and a dynamic financial sector are essential for the proper functioning of any decentralised market economy; I also believe that too much financial sector activity is not only socially worthless, but actually harmful. Take financial derivatives. ... To tame the rampant excessive speculation in the derivatives markets, it is sufficient to require that at least one of the parties involved in a derivatives transaction has an insurable interest. The Tobin tax does nothing to achieve this. ...
“Churning” can be a problem for individual savers. Excessive transaction volumes can be caused by perverse incentive systems that link the remuneration of traders – acting as agents for owners of wealth – to trading volumes. Even here, the right solution is not transaction taxes but regulation restricting the undesirable features of these contracts directly. If excessive pay in the financial sector is a problem, tax pay.
I agree with Lord Turner that the UK financial sector – too large to fail and possibly also too large to save – has become a destabilising force for the UK. ... One can share Lord Turner’s diagnosis that the UK financial sector was allowed to grow too large and to get out of control – almost a law unto itself – without accepting the Tobin tax as part of the solution. Tobin was a genius, but the Tobin tax was probably his one daft idea. Creating a viable and socially useful UK financial sector does not require this unfortunate fiscal intervention.

The efficiency properties of the tax depend upon how speculation is viewed. If you believe speculation is efficiency enhancing, and it can be, then reducing speculation would reduce rather than increase efficiency. But if you believe speculation is destabilizing, and it can be this too, then reducing speculation would be beneficial. I am not as negative toward speculation as many, and believe that while it can be both good and bad from a market efficiency perspective, on net, it does good. A general tax would reduce both the good and bad types of speculation, so it is not clear to me that this would be beneficial. I would prefer a mechanism that targets that bad speculation, but leaves the good type alone, but since it is difficult to tell the two apart, even ex-post, it is not practical to levy a tax on just the bad transactions while giving the good ones a free pass. But it may be possible to target the underlying market failures and distortions driving the problems in financial markets, which amounts to the same thing, and these extend far beyond just speculative ventures. Thus, I am somewhat persuaded by Buiter's argument that "public interventions to correct distortions and other market failures should be targeted directly at the distortion or failure in question." It's not clear a financial transactions tax has this property.

From a revenue point of view, the calculation is different. Given the government's spending needs (whatever they are), the question is how to best raise the revenue to pay for that spending. In that regard, the question is whether a financial transactions tax would be the least distortive (and fairest) means of raising the revenue needed to support government spending. Since I am somewhat on the fence regarding speculation, there is good speculation and bad speculation and it's not clear which prevails (though I give an edge to the good type), it may be that a tax of this type creates more distortions than it resolves. However, that also means that it may not create, on net, as many distortions as the next best alternative tax that would raise the same amount of revenue, and hence a financial transactions tax may be a desirable way to provide additional funds to the government.

Update: More reactions to the tax at Salvation or suicide? Experts react to a Tobin tax.

Monday, August 03, 2009

Paul Krugman: Rewarding Bad Actors

Is what’s good for Wall Street also good for America?:

Rewarding Bad Actors, by Paul Krugman, Commentary, NY Times: Americans are angry at Wall Street, and rightly so. First the financial industry plunged us into economic crisis, then it was bailed out at taxpayer expense. And now, with the economy still deeply depressed, the industry is paying itself gigantic bonuses. If you aren’t outraged, you haven’t been paying attention. ...

Consider two recent news stories. One involves ... high-speed trading: some institutions, including Goldman Sachs, have been using superfast computers to get the jump on other investors... Profits from high-frequency trading are one reason Goldman is earning record profits and likely to pay record bonuses.

On a seemingly different front,... Andrew J. Hall, who leads an arm of Citigroup that speculates on oil and other commodities ... has made a lot of money recently... Mr. Hall is owed $100 million.

What do these stories have in common?

The politically salient answer ... is that ... both ... firms ... were major recipients of federal aid. Citi has received around $45 billion...; Goldman has repaid the $10 billion it received..., but it has benefited enormously both from federal guarantees and from bailouts of other financial institutions. What are taxpayers supposed to think when these welfare cases cut nine-figure paychecks?

But suppose we grant that both Goldman and Mr. Hall are very good at what they do, and might have earned huge profits even without all that aid. Even so, what they do is bad for America.

Just to be clear: financial speculation can serve a useful purpose. It’s good, for example, that futures markets provide an incentive to stockpile heating oil before the weather gets cold...

But speculation based on information not available to the public at large is a very different matter. As the U.C.L.A. economist Jack Hirshleifer showed back in 1971, such speculation often combines “private profitability” with “social uselessness.”

It’s hard to imagine a better illustration than high-frequency trading. The stock market is supposed to allocate capital to its most productive uses... But it’s hard to see how traders who place their orders one-thirtieth of a second faster than anyone else ... improve that social function.

What about Mr. Hall? The Times report suggests that he makes money mainly by outsmarting other investors, rather than by directing resources to where they’re needed. Again, it’s hard to see the social value...

And there’s a good case that such activities are actually harmful. For example, high-frequency trading [is] ... a kind of tax on investors who lack access to ... superfast computers — which means that the money Goldman spends on those computers has a negative effect on national wealth. As ... Kenneth Arrow put it in 1973, speculation based on private information imposes a “double social loss”: it uses up resources and undermines markets. ...

And soaring incomes in the financial industry have played a large role in sharply rising income inequality.

What should be done? Last week the House passed a bill setting rules for pay packages at a wide range of financial institutions. That would be a step in the right direction. But it really should be accompanied by much broader regulation of financial practices — and, I would argue, by higher tax rates on supersized incomes.

Unfortunately, the House measure is opposed by the Obama administration, which still seems to operate on the principle that what’s good for Wall Street is good for America.

Neither the administration, nor our political system in general, is ready to face up to the fact that we’ve become a society in which the big bucks go to bad actors, a society that lavishly rewards those who make us poorer.

[See also Back to the Good Times on Wall Street: Looking at "nine large financial institutions that received substantial TARP support from the government," "the firms’ post-crisis pay policies appear to be ... even more lucrative to the firms’ employees than pre-crisis policies.]

Tuesday, July 28, 2009

Equity and Efficiency in Health Care Markets

This is an attempt to clarify a few of the remarks I've made over the last several days regarding the need for government intervention in health care markets.

There are two separate reasons to intervene, market failure and equity. Taking market failure first, there are a variety of failures in health care and insurance markets such as asymmetric information, market power, and principal agent problems. These can be solved by the private sector in some cases, but in others government intervention is required.

But even if the private sector or the government can solve the market failure problems adequately, there's no guarantee that the resulting distribution of health care services will be equitable. We don't expect the private sector to, for example, make sure that everyone can live on the coast and have an ocean view if they so desire, we use market prices to ration those goods, but we may want to make sure that everyone can get health care when they have serious illnesses. So equity considerations may prompt the government to intervene and bring about a different distribution of health care services than would occur with an efficient market.

I believe that economists have something to offer in both cases. In the first, economic theory offers solutions to market failures, and though not every market failure can be completely overcome, the solutions can guide effective policy responses. I prefer market-based regulation to command and control solutions whenever possible, i.e. I prefer that government create the conditions for markets to function rather than direct intervention. But sometimes the only solution is to intervene directly and forcefully.

In the second case, the idea is a bit different. Here, equity is the issue so somehow society must first designate the outcome it is trying to produce before economists can help to achieve it. Right now, it is my perception that the majority of people want to expand to universal or near universal coverage if we can do so without breaking the bank, and without reducing the care they are used to. If we can find a way to do that, the majority will come on board. If that's the case, if that's what we have collectively decided we want, then the job of the economists is to find the best possible way of achieving that outcome (or whatever outcome is desired) given whatever constraints bind the process (whether political realities should be part of the set of constraints is a point of contention, so I'll stay silent on that).

So if we are only concerned about efficiency, we do our best to resolve the market failures and leave it at that. We make sure, for example, that people have the information they need to make informed decisions about their care, that there aren't incentives that cause doctors to order too much or too little of some type of care or test, that monopoly power is checked, etc., etc. There's no guarantee that everyone will receive care, or that the distribution of care among those who do receive care will be as desired.

But if we are concerned with equity too - and most of us aren't comfortable watching people suffer when we know that help is readily available (perhaps nature imposes this externality upon us purposefully) - if we won't let people die on the street or suffer needlessly due to our sense of fairness and equity - then we will want to intervene to achieve broad based coverage in the least cost and fairest manner we can find (and there may be other equity issue that are important too).

Both reasons, equity and efficiency, can justify government intervention into health care markets. I think equity is of paramount importance when it comes to health care, so for me that is enough to justify government intervention, and the existence of market failure simply adds to the case that government intervention is needed.

So those opposed to government involvement in health care markets have to first argue that there is no market failure significant enough to justify intervention, a tough argument in and of itself, and also argue that people who, for example, go without insurance or cannot afford the basic care they need deserve no compassion whatsoever from society more generally. That's an argument I could never make even for those who could have paid for insurance but chose to take a chance they wouldn't need care, let alone for those who cannot afford it under any circumstances. I want everyone to be covered as efficiently as possible, and to be required to pay their fair share of the bill, whatever that might be, for the care that's made available to them.

Monday, July 27, 2009

Update to "A Breakthrough in the Fight against Hunger"

The post "A Breakthrough in the Fight against Hunger" summarizes Jeff Sachs' favorable view of the G-8’s $20bn initiative on smallholder agriculture (e.g. to provide assistance buying seed and fertilizer), and also gives Murat Iyigun's view of the type of developmental assistance advocated by many economists. Since Iyigun mentions Bill Easterly explicitly, and since Easterly and Sachs have an ongoing debate on this (and many other) issues, I promised an update if Bill Easterly responded. I just received this email:

Sachs mentions the lessons of history, but doesn't acknowledge the nearly universal agreement that past efforts at African Green Revolutions (with the same list of interventions that Sachs lists) have failed (see the documentation in my recent JEL article -- ungated version here). That doesn't mean giving up, but it does mean learning from history, trying to figure out why it failed in the past and correcting it -- why does Sachs find this idea so threatening?

On Iyigun's blog, I'm so happy to finally find somebody who gets it, that you shouldn't invade countries based on economists' crappy econometrics, that I have nothing else to add. I have had a lot more difficulty convincing people of this than I expected.

Adverse Selection

With health care reform in the news, there's been quite a bit of talk about adverse selection and the degree to which it is actually a problem in health care and health insurance markets. Some people have even gone so far as to question whether significant adverse selection effects exist at all outside of textbooks since when they look at the marketplace, they have a hard time finding it.

But the thing is, if you go looking for it in the marketplace, you aren't likely to find it. Unless the problem has been largely overcome either the government intervention or the through private sector institutions constructed to fix the problem (generally intermediaries who can solve the information problem that generates the market failure), the market will fail to exist at all. So you will either observe a fairly well-functioning market that has overcome the problem, or you won't see a market at all.

So if you want evidence of adverse selection, you should look for the institutions designed to overcome the problem - e.g. used car dealers with the expertise needed to  overcome the one-sided information problem on car quality, and then issue quality guarantees (or develop a reputation for quality) acting as intermediaries, that sort of thing - and those types of intermediaries are easy to find. Evidence of the institutions needed to overcome adverse selection - and evidence that the problem exists - aren't hard to find. Furthermore, very often government intervention isn't needed, the market can solve this on its own.

And the market will solve it on its own in the case of health care, but we may not like the solution the market comes up with. First, it violates our sense of equity since the solution will be to prevent people likely to have high health costs from getting insurance (or the price of insurance will be so high that they are effectively excluded). But we will still have to provide for them, we can't just abandon them to suffer when help can be provided. It's one thing if someone cannot sell their car due to market failure, it's quite another if they cannot get the medicine or care they need to maintain their health. So the private sector solution may not be morally acceptable. Second, because we have to provide for the sick in any case, the resources that are devoted to excluding people are wasted resources, all that happens is that the problem is shunted off to a generally more expensive option.

So it's not that the private sector cannot solve this problem at all, that's not why we need government to intervene, it's that the solution the market imposes violates our moral sensibilities and wastes resources that could be used more productively.

[On the run today and writing this sitting in my car in a parking lot. Mobility is getting better.]

Update: Thinking about this a bit more, I don't think I want to stand behind the claim that finding evidence of adverse selection is unlikely, for example the consequences of missing markets may be evident in the data (technically the search is then outside of the marketplace, but I still don't want to push this). And I also overstated the extent to which the private sector can solve the adverse selection problem, there are problems that I think the private sector cannot resolve, problems that require government involvement (e.g. mandates). But I do want to comment on this from Megan McArdle:

Of course, it's also true that the population of the uninsured is correlated with something that's also correlated with good health:  being young.  But then, this sort of undercuts the adverse selection argument, and also the moral imperative of giving them health insurance.  If you could reasonably afford health insurance by dropping down to a lower-priced cell phone plan and cutting back on your bar tab, you are not a national emergency.

But this is, in fact, a good example of market failure and why government intervention is sometimes needed. So long as people know that they can get care for life threatening illnesses, broken bones, that sort of thing, and even for less threatening ailments, they have no incentive to cut back on these other expenditures. They get roughly the same care whether they drop their cell plan and the bar tab or not, so why bother? That's why the government has to mandate coverage, so they are forced to pay their share. Sure, we can say it's a moral issue, that they shouldn't do this, but if they do it anyway then it's all of us, not the people choosing to forgo insurance, who end up picking up the tab. If we are willing to say "let them suffer for their choices, even die for them" then sure, there's no market failure here, they will know that and get insurance (maybe - it's rational to do so, but will they behave rationally?). But I am going to help if I can when health is significantly threatened (even if just to save them from themselves in some cases) - I think most people would - and that leaves the market failure door wide open (I'm not addressing the presumption that people without insurance have cell phones and bar tabs rather than necessities they can cut out in order to afford insurance - that's not, of course, always true).

Saturday, July 18, 2009

"Let The Good Times Roll Again?"

The question of how to interpret Goldman Sachs' unexpectedly large earnings has been addressed here and here (with an addendum at the bottom of the second post). One lesson appears to be that the bad incentives underlying executive compensation are still be present. However, exactly why that is the case - other than the sheer size of the profits - has not been fully addressed. This argument from Lucian Bebchuk takes a step in that direction by noting that the Goldman Sachs' bonuses are a reward for short-term gains, when we ought to be tying compensation to long-run performance. Thus, the problematic incentive to take on large amounts of risk in pursuit of immediate profits is still present. (Though it's not included below, he also argues that compensation should be based upon the long-run value of a broad basket of securities, not just common shares as has been typical in the past, to avoid distorting incentives in a way that gives executives another reason to take on too much risk):

Let the good times roll again?, by Lucian Bebchuk, Commentary, Project Syndicate: Goldman Sachs announced this month plans to provide bonuses at record levels, and there are widespread expectations that bonuses and pay in many other firms will rise substantially this year. Should the good times start rolling again so soon?

Not without reform. Indeed, one key lesson of the financial crisis is that an overhaul of executive compensation must be high on the policy agenda.

Indeed, pay arrangements were a major contributing factor to the excessive risk-taking by financial institutions that helped bring about the financial crisis. By rewarding executives for risky behaviour, and by insulating them from some of the adverse consequences of that behaviour, pay arrangements for financial-sector bosses produced perverse incentives, encouraging them to gamble.

One major factor that induced excessive risk-taking is that firms’ standard pay arrangements reward executives for short-term gains, even when those gains are subsequently reversed. Although the financial sector lost more than half of its stock-market value during the last five years, executives were still able to cash out, prior to the stock market implosion, large amounts of equity compensation and bonus compensation.

Such pay structures gave executives excessive incentives to seek short-term gains ... even when doing so would increase the risks of an implosion later on. ...

Following the crisis, this problem has become widely recognised... But it still needs to be effectively addressed: Goldman’s recent decision to provide record bonuses as a reward for performance in the last two quarters, for example, is a step in the wrong direction.

To avoid rewards for short-term performance and focus on long-term results, pay structures need to be re-designed. As far as equity-based compensation is concerned, executives should not be allowed to cash out options and shares given to them for a period of, say, five years after the time of “vesting”...

Similarly, bonus compensation should be redesigned to reward long-term performance. For starters, the use of bonuses based on one-year results should be discouraged. Furthermore, bonuses should not be paid immediately, but rather placed in a company account for several years and adjusted downward if the company subsequently learns that the reason for awarding a bonus no longer holds up. ...

A thorough overhaul of compensation structures must be an important element of the new financial order.

The latest I'm aware of on this topic is draft legislation Barney Frank circulated today:

All publicly traded U.S. companies, and particularly financial firms, would face new executive-compensation requirements under draft legislation circulated Friday by a top lawmaker in the U.S. House of Representatives.

The measure proposed by Rep. Barney Frank, D-Mass., would give shareholders a greater ability to weigh in on compensation packages, require compensation consultants to satisfy independence criteria established by the government and would ensure that compensation committees are made up of independent directors. ...

Banks, broker-dealers, investment advisers and all other financial firms would be required to disclose any incentive-based compensation structures, while federal regulators would be able to limit "inappropriate or imprudently risky" pay practices.

The panel is expected to take up some form of the legislation next week.

This legislation would give regulators the power to limit executive pay structures that they believe are excessively risky, but exactly what types of compensation structures would be allowed or required under this legislation is a bit vague. It doesn't sound like it will be as restrictive as Lucian Bebchuk would like, but we shall see.

There are two related issues here. First, was the compensation fair in terms of being a reward for productive activities such as directing capital where it was most needed, or distributing and reducing risk? Before the crash, some people tried to make that argument, but for financial executives, it seems clear that the compensation was based upon bubble rather than fundamental values, and that this lead to inflated rewards relative to the value that was actually created. But even for non-financial executives, it's hard to believe that the generous compensation high-level managers and executives received in recent years is due entirely to their superior productivity. The "say on pay" part of the proposed legislation tries to give shareholders a greater voice in setting compensation levels, and is directed at this problem.

The second issue is whether the compensation structures that have been used in the past lead to incentives to accumulate more risk than is optimal. It appears that they did, and the second part of the proposal is an attempt to overcome this problem by giving regulators the ability to limit systemically risky practices.

There are two types of excessive risk to be worried about, but only one is a systemic risk, i.e. a risk to the overall economy. First, a particular executive compensation structure may give an executive the incentive to take on too much risk - more than shareholders desire - but there is no danger to the overall financial system. This type of excessive risk taking needs to be prevented, but it is not a danger to the overall economy, and regulators are generally concerned with microeconomics questions concerning optimal incentive structures. Second, there is excessive risk that endangers the entire financial system and the broader economy. This is systemic risk that is the target of the proposed legislation, the kind of risk regulators such as the Fed are concerned with, and the kind we must do our best to eliminate if we want to avoid a repeat of the present crisis.

To me, both elements of the proposed legislation - the part that gives shareholders the power to limit compensation levels and the part that gives regulators the power to limit risky compensation schemes - seem vague and rather weak. I hope that changes as the legislation develops.

Tuesday, July 07, 2009

"U.S. Revives Section 2 of the Antitrust Act"

Since I've argued that the enforcement of antitrust law hasn't been strict enough many times in the past -- "the idea that markets 'self-police'" anti-competitive behavior always seemed much more of a hope than a reality in my view of the evidence -- to me this is good news (but it's not good news to everyone). It's not just the textbook economic effects of monopoly power that are worrisome, it's also the ability of large and powerful firms to tilt regulation and legislation in their favor:

Sherman Stirs: U.S. Revives Section 2 of the Antitrust Act, by Ashby Jones. WSJ: For nearly 120 years, the Sherman Antitrust Act has been the main vehicle through which the government and private parties have regulated the so-called anticompetitive behavior of corporate America.

The act's two main sections target vastly different types of behavior, though each may result in both civil liability and criminal punishment.

Section 1 largely addresses situations involving anticompetitive behavior of two or more entities working in concert. Cases involving price-fixing and market-division arrangements are typically brought under Section 1.

Section 2 cases typically involve the behavior of one firm, acting alone. Section 2 cases generally require a private party or the government -- either the Department of Justice or the Federal Trade Commission -- to show that a firm with a significant market share has done something anticompetitive in order to increase or maintain its monopoly. Monopolies, without evidence of anticompetitve behavior, aren't necessarily illegal.

While Section 1 cases are fairly common, the bulk of the headline-grabbing antitrust cases have been under Section 2... John D. Rockefeller's Standard Oil Co. ... AT&T... Microsoft ...

Enforcement of Section 2 went largely dormant under President George W. Bush. Toward the end of his second term, the administration issued a report which codified its views on Section 2. It took the position that the marketplace, not government regulators or courts, provides the ideal check on anticompetitive business practices.

In May, Christine Varney, President Barack Obama's pick to run the Justice Department's antitrust division, repudiated the Bush administration report, squarely placing some blame for the country's economic problems on the Bush administration's laissez-faire regulatory policies.

"Americans have seen firms given room to run with the idea that markets 'self-police' and that enforcement authorities should wait for the markets to 'self-correct,' " Ms. Varney said at the time. "Ineffective government regulation, ill-considered deregulatory measures and inadequate antitrust oversight contributed to the current conditions ... we cannot sit on the sidelines any longer."

Antitrust experts weren't surprised by Monday's news that with an initial review of conduct by large U.S. telecom companies [such as AT&T and Verizon], the Justice Department had started dusting off Section 2. ..

Wednesday, June 24, 2009

"Obama and 'Regulatory Capture'"

Thomas Frank says the administration's regulatory overhaul plan is not putting enough emphasis on the problem of regulatory capture:

Obama and 'Regulatory Capture', by Thomas Frank, Commentary, WSJ: ...We have just come through the most wrenching financial disaster in decades, brought about in no small part by either the absence of federal regulation or the amazing indifference of the regulators.

This is the moment for a ringing reclamation of the regulatory project. President Barack Obama is clearly the sort of man who could do it. But ... a white paper his administration released on the subject last week ... uses bland, impersonal explanations for the current crisis. Regulatory agencies were ill-designed... Their jurisdictions overlapped. They had blind spots. They had been obsolete for years.

All of which is true enough. What the report leaves largely unaddressed, however, is the political problem. ... The people who filled regulatory jobs in the past administration were asleep at the switch because they were supposed to be. ...

The reason for that is simple: There are powerful institutions that don't like being regulated. Regulation sometimes cuts into their profits... So they have used the political process to sabotage, redirect, defund, undo or hijack the regulatory state since the regulatory state was first invented.

The first federal regulatory agency, the Interstate Commerce Commission, was set up to regulate railroad freight rates in the 1880s. Soon thereafter, Richard Olney, a prominent railroad lawyer, came to Washington to serve as Grover Cleveland's attorney general. Olney's former boss asked him if he would help kill off the hated ICC. Olney's reply ... should be regarded as an urtext of the regulatory state:

"The Commission . . . is, or can be made, of great use to the railroads. It satisfies the popular clamor for a government supervision of the railroads, at the same time that that supervision is almost entirely nominal. Further, the older such a commission gets to be, the more inclined it will be found to take the business and railroad view of things. . . . The part of wisdom is not to destroy the Commission, but to utilize it."

The George W. Bush administration elevated this strategy to a snickering, sarcastic art form. It gave us a Food and Drug Administration that sometimes looked as though it was taking orders from Big Pharma, an Environmental Protection Agency that could never rouse itself from the recliner, an energy policy that might well have been dictated by Enron, and a Consumer Product Safety Commission that moved like a rusty wind-up toy.

And it created a situation where banking regulators posed for pictures with banking lobbyists while putting a chainsaw to a pile of regulations. ...

Misgovernment of this kind is not a partisan phenomenon, of course. Democrats have been guilty of it as well as Republicans. ... Yet today we talk around this problem, with its nose-on-your-face obviousness, as though it didn't exist. It's not until page 29 of the Obama administration's densely worded white paper that you find a reference to "regulatory capture," and then it is buried in a list of items to be considered by a future Treasury working group. ...

[T]he administration must go further. ... After all, the Bush team was only able to install the dreadful regulators it did because the governance of federal agencies was rarely a topic of public debate in those days. Mr. Obama should make it an unavoidable subject, something that future politicians will be required to address. The issue cries out for it. And the nation, for once, is listening.

I see this a little bit different. I think the regulatory capture that helped to open the door for the current crisis had more to do with the adoption and promotion of free market ideology and the culture that ideology brought about within the regulatory bodies than to direct capture by regulated industries.

The financail industry certainly promoted the free market, self-healing, self-regulating approach since it coincided with their interests in shedding regulatory constraints, and they also aided politicians who promoted these ideas. Those politicians, in turn, made appointments to key positions within regulatory agencies that were designed to further this ideology and that, too, contributed to the changing culture within the regulatory bodies.

But the idea that, in almost all cases cases markets will self-correct and self-regulate, and that society is best served with a hands off approach to these markets, did not originate within industry. It came from a dominant strain of economic thought supported by theoretical models and empirical evidence. Without the support of these models, the empirical evidence, and the many economists who carried the message - and most of the profession did - it would have been much more difficult for industry to successfully promote the "deregulation is good for everybody always and everywhere" within the political and regulatory arenas.

I don't want to be mistaken here, I still believe that most markets function well with minimal regulation, and that a hands off approach is generally best. But I hope we have learned that financial markets are not among the markets for which this is true. I also hope that, as a profession, we will be more receptive to the idea that markets can fail, and can do so catastrophically, that we will build models that help us to better understand how to minimize the risk that markets will break down, and more importantly that we will interpret data with this in mind. All of the data in the world is useless if you cannot see, refuse to see, or cannot accept what it is trying to tell you.

Tuesday, June 23, 2009

"Incomplete Contracts and Brinkmanship"

Regulation can be roughly categorized as being one of two types, rules based and principles based. With rules based regulation, behaviors are explicitly ruled out through an extensive set of regulations, ordinances, laws, and the like, whereas with principles based regulation a broad set of guidelines outlining the principless regulators are trying to enforce is issued, then the regulators take whatever steps are needed to enforce those principles.

This post from Jeff Ely at Cheap Talk can be used to highlight a connection between complete/incomplete contracts and rules/principles based regulation:

Incomplete Contracts and Brinkmanship in the iPhone App Store, by Jeff Ely: One of the highly touted features of the iPhone is the abundance of applications...  In traditional Apple fashion,... Apple exercises strict control over which apps are made available through the app store. Short of jailbreaking your phone, there is no other way to install third-party software.

The process by which apps are submitted and reviewed strikes many as highly inefficient.  (It also strikes many as anti-competitive, but that is not the subject of this post...) Developers sink significant investment producing launch-ready versions of their software and only then learn definitively whether the app can be sold. There is no recourse if the submission is denied.

(Just recently, we witnessed an extreme example of the kind of deadweight loss that can result.  A fully licensed, full-featured Commodore64 Operating System emulator, 1 year in the making, was just rejected from the app store. )

Unfortunately, this is an inevitable inefficiency due to the ubiquitous problem of incomplete contracting.  In a first-best world, Apple would publicize an all-encompassing set of rules outlining exactly what software would be accepted and what would be rejected.  In this imaginary world of complete contracts, any developer would know in advance whether his software would be accepted and no effort would be wasted.

In reality it is impossible to conceive of all of the possibilities, let alone describe them in a contract.  Therefore, in this second-best world, at best Apple can publish a broad set of guidelines and then decide on a case-by-case basis when the final product is submitted.  This introduces inefficiencies at two levels.  First, the direct effect is that developers face uncertainty whether their software will pass muster and this is a disincentive to undertake the costly investment at the beginning.

But the more subtle inefficiency arises due to the incentive for gamesmanship that the imperfect contract creates.  First, Apple’s incentive in constructing guidelines ex ante is to err on the side of appearing more permissive than they intend to be.  Apple ... values the option to bend the (unwritten) rules a bit when a good product materializes.  ...

Second, because Apple cannot predict what software will appear it cannot make binding commitments to reject software that is good but erodes slightly their standards.  This gives developers an incentive to engage in a form of brinkmanship:  sink the cost to create a product highly valued by end users but which is questionable from Apple’s perspective.  By submitting this software the developer puts Apple in the difficult position of publicly rejecting software that end users want and the fear of bad publicity may lead Apple to accept software that they would have like to commit in advance to reject.

The iPhone app store is only a year old and many observers think of it as a short-run system that is quickly becoming overwhelmed by the surprising explosion of iPhone software.  When the app store is reinvented, it will be interesting to see how they approach this unique two-sided incentive problem.

To see the connection, here are a few sections from above rewritten so that the Fed rather than Apple is the regulator:

Unfortunately, an inevitable inefficiency arises due to the ubiquitous problem of incomplete contracting. In a first-best world, The Fed would publicize an all-encompassing set of rules outlining exactly what would be accepted and what would be rejected.  In this imaginary world of complete contracts, any financial institution would know in advance whether the new financial product they have created would be accepted and no effort would be wasted.

In reality it is impossible to conceive of all of the possibilities, let alone describe them in a contract. Therefore, in this second-best world, at best the Fed can publish a broad set of guidelines and then decide on a case-by-case basis when the financial product is submitted. This introduces inefficiencies at two levels. First, the direct effect is that financial firms face uncertainty whether their new products will pass muster and this is a disincentive to undertake the costly investment at the beginning.

Second, because the Fed cannot predict what new products will appear it cannot make binding commitments to reject a product that is good but erodes slightly their standards. This gives financial institutions an incentive to engage in a form of brinkmanship:  sink the cost to create a product highly valued by end users but which is questionable from the Fed’s perspective. By submitting this product the financial institution puts Apple in the difficult position of publicly rejecting products that end users want and the fear of bad publicity may lead the Fed to accept products that they would have liked to have committed in advance to reject.

I don't think it's one or the other, there's room for both, and principles based seems useful when it's difficult to explicate all the ways to bypass a particular rule (e.g. the designer drug issue).

But I'm not sure that the distinction between the two types of regulation is all that useful - I find it hard to draw a clear line that separates one from the other - and I doubt most of you are much interested in the topic.

So let me make a comment about Apple. The monopoly problem is set aside here, but I think it's part of the problem. If other competitors existed, it wouldn't necessarily be an all or nothing proposition for applications. If it doesn't make it at one outlet, you can always try another if the marketplace is competitive (and the competition should also help to move the regulation to an optimal configuration, at least in theory). It might take some amendments to the code, but once something is built it's usually not too hard to rewrite it in a different language. Thus, though more competition wouldn't completely eliminate the problem, it would certainly help.

But what I don't understand is why they don't allow pre-approval. Why can't you submit an idea and say something like "my app will emulate Commodore64 Operating System, will you accept that?" Apple might be worried about, say, security holes with a particular app and it may not be able to fully judge this until the code is actually written, but this condition could be written into the pre-approval, and pre-approval would encourage more development while also cutting down on their workload to approve apps after they are developed (since many wopuld be pre-screened). And I think financial regulators could do the same thing, review proposed products prior to their actual development to reduce the waste associated with the development of new products.

Saturday, June 13, 2009

Climate Plans and Carbon Markets

Jeffrey Sachs says markets alone are not enough to solve the climate change problem, we also need strategic direction from "detailed and coherent" government plans:

Still Needed: A Climate Plan, by Jeffrey Sachs, Scientific American: There is a myth in America that markets, not plans, are the key to success. Markets will supposedly decide our climate future on their own once we institute cap-and-trade legislation to put a market price on carbon emissions. But this is silly: both markets and planning are essential in any successful large-scale undertaking, whether public or private. We need a detailed yet adaptable road map for action that goes far beyond cap and trade. ...

The administration’s climate negotiator has called cap and trade "the centerpiece" of the domestic climate program. A moment’s reflection shows why that cannot be right. Cap and trade will have little effect, for example, on whether the U.S. revives its nuclear power industry, as it should to meet climate objectives. A renaissance for nuclear will depend on regulations, public attitudes, liability laws, and both administration leadership and public education much more than on cap and trade, which would play at most a supporting role.

Continue reading "Climate Plans and Carbon Markets" »

Thursday, May 28, 2009

"Crazy Compensation and the Crisis"

Alan Blinder urges "corporate boards of directors and, in particular, of their compensation committees" to create compensation plans for financial firms that discourage excessive risk taking:

Crazy Compensation and the Crisis, by Alan Blinder, Commentary, WSJ: Despite the vast outpouring of commentary and outrage over the financial crisis, one of its most fundamental causes has received surprisingly little attention. I refer to the perverse incentives built into the compensation plans of many financial firms, incentives that encourage excessive risk-taking with OPM -- Other People's Money.

What, you say, hasn't huge attention been paid to executive compensation...? Yes. But the ruckus has been over the generous levels of compensation,... not over the dysfunctional incentives...

Take a typical trader at a bank, investment bank, hedge fund or whatever. ... Unfortunately, their compensation schemes ... offer.. them the following sort of go-for-broke incentives when they place financial bets: Heads, you become richer than Croesus; tails, you get no bonus, receive instead about four times the national average salary, and may (or may not) have to look for a new job. ...

[L]et's consider the incentives facing the CEO and other top executives... For them, it's often: Heads, you become richer than Croesus ever imagined; tails, you receive a golden parachute that still leaves you richer than Croesus. So they want to flip those big coins, too.

From the point of view of the companies' shareholders -- the people who provide the OPM -- this is madness. ... Traders and managers both want to flip more coins -- and at higher stakes -- than shareholders would if they had any control, which they don't.

The source of the problem is really quite simple: Give smart people go-for-broke incentives and they will go for broke. Duh.

Amazingly, despite the devastating losses, these perverse pay incentives remain the rule on Wall Street today, though exceptions are growing. ... These wacky compensation schemes have puzzled me for nearly 20 years. ... But the issue could be considered an intellectual puzzle until the bottom fell out. ... after an orgy of irresponsible risk taking... [T]he consequences for the real economy have been devastating. ...

What to do? It is tempting to conclude that the U.S. (and other) governments should regulate compensation practices.... But the ... executives, lawyers and accountants who design compensation systems are imaginative, skilled and definitely not disinterested. Congress and government bureaucrats won't beat them at this game.

Rather, fixing compensation should be the responsibility of corporate boards of directors and, in particular, of their compensation committees. These boards, ... are supposed to represent the interests of stockholders, not those of managers. ... The unhappy (but common) combination of coziness and drowsiness in corporate boardrooms must end. ... For example, top executives could be paid mainly in restricted stock that vests at a later date, and traders could have their winnings deposited into an account from which subsequent losses would be deducted.

Comprehensive reform of the financial system will probably take years. The problems are many and complex, and the government's to-do list is not only long but also a political minefield. Yet fixing compensation incentives does not require any government action. It can be done by financial companies, tomorrow. Too bad they didn't do it yesterday.

But how is the board of directors chosen? See also:

The SEC's Proxy Access Proposal, by Lucian Bebchuk: The Securities and Exchange Commission voted last week to ask the public to comment on a proposal to let shareholders place director candidates on the corporate ballot. The adoption of such a rule would be a useful step toward the necessary reform of corporate elections. ...

Saturday, May 23, 2009

The Decline of Merit Pay in Journalism

David Cay Johnston on the job market for journalists:

Welcome to the Jungle, by David Cay Johnston, CJR: Reporter Dan Browning’s piece on coming newsroom cuts at the St. Paul Pioneer-Press contains a curious detail that perhaps will encourage rigorous thinking in articles covering compensation. “The company said it wants… the elimination of merit pay….” Browning wrote... The term “merit pay” usually means that management rewards superior performance with superior compensation. ...

There is an adage among business owners ... that properly priced labor pays for itself. Workers whose pay equals their economic value-added receive just what they contribute and, in effect, cost the employer nothing. Those who are underpaid, however, damage profits through inefficiency, because when you underpay you attract less efficient workers. On the other end, those ... who are overpaid rob the owners of part of their profits.

So what does it say that Pioneer Press ... wants to stop rewarding superior performance with appropriately superior pay?

In theory, the best workers will go elsewhere. After all, the highest performers will be in demand and others will bid for their talent. The theory of market economics says that ... the quality of the labor ... will diminish, with appropriate damage to ... equity.

Continue reading "The Decline of Merit Pay in Journalism" »

Monday, May 11, 2009

Antitrust Enforcement

This is a welcome change. I've long been an advocate of stepped up enforcement of antitrust law, mostly because of the economic consequences of monopoly power. But the financial crisis has caused me to realize how much political power comes with dominance in the marketplace, and that is another reason to take a more aggressive approach to antitrust enforcement:

Administration Plans to Strengthen Antitrust Rules, by Stephen Labaton, NY Times: President Obama’s top antitrust official this week plans to restore an aggressive enforcement policy against corporations that use their market dominance to elbow out competitors or to keep them from gaining market share. The new enforcement policy would reverse the Bush administration’s approach, which strongly favored defendants against antitrust claims. ...

The head of the Justice Department’s antitrust division, Christine A. Varney, is to announce the policy reversal in a speech she will give on Monday... The administration is hoping to encourage smaller companies in an array of industries to bring their complaints to the Justice Department about potentially improper business practices by their larger rivals. Some of the biggest antitrust cases were initiated by complaints taken to the Justice Department.

Ms. Varney is expected to say that the administration rejects the impulse to go easy on antitrust enforcement during weak economic times. She will assert instead that severe recessions can provide dangerous incentives for large and dominating companies to engage in predatory behavior that harms consumers and weakens competition.

The announcement is aimed at making sure that no court or party to a lawsuit can cite the Bush administration policy as the government’s official view in any pending cases. ... Ms. Varney is expected to explicitly warn judges and litigants in antitrust lawsuits not involving the government to ignore the Bush administration’s policies...

During the Bush administration, the Justice Department did not file a single case against a dominant firm for violating the antimonopoly law. Many smaller companies complaining of abusive practices by their larger rivals were so frustrated by the Bush administration’s antitrust policy that they went to the European Commission and to Asian authorities. ...

Ms. Varney is expected to say that the Obama administration will be guided by the view that it was a major mistake during the outset of the Great Depression to relax antitrust enforcement, only to try to catch up and become more vigorous later. She will say the mistake enabled many large companies to engage in pricing, wage and collusive practices that harmed consumers and took years to reverse.

While Ms. Varney is not expected to mention any specific companies or industries..., she is aiming at agriculture, energy, health care, technology and telecommunications companies. She may also be reviewing the conduct of some in the financial services industry...

Signaling her intent to revive a moribund antitrust program, she has recruited a collection of senior aides, many of whom are seasoned antitrust litigators or worked in the Clinton administration and the Federal Trade Commission and were involved in many prominent cases, including the one against Microsoft. ...

Sunday, May 03, 2009

"Troubled Banks Must be Allowed a Way to Fail"

Kansas City Fed president Thomas Hoenig has a plan for allowing large and systemically important banks to fail. If we prevent financial institutions from becoming so large and systemically important in the first place, the plans below wouldn't be needed. But if we going to allow such institutions to exist - not my first choice but for now we have what we have - then this is a reasonable approach to take. One difference I have, though, is that I think that stronger form of guarantee for depositors, a key component of the Swedish plan, is needed. That changes the equity calculations when you look solely at the flow of money to depositors, and the politics of that aren't great, but the improved overall outcome can more than compensate for the cost of the government guarantees:

Troubled banks must be allowed a way to fail, by Thomas Hoenig, Commentary, Financial Times: When the financial crisis began ... in 2007, US policymakers reacted quickly out of fear that ... events would lead to a global economic collapse. In my view, the policy response ... has been ad hoc, resulting in inequitable outcomes among firms, creditors, and investors. Despite taking a number of actions..., uncertainty continues and markets remain stressed.

I believe there is an alternative method for addressing this crisis...: the implementation of a systematic plan to resolve large, problem financial institutions. ... Boiled down..., the plan would require those firms seeking government assistance to make the taxpayer senior to all shareholders, with the government determining the circumstances for managers and directors. ...

Non-viable institutions would be allowed to fail and be placed into a negotiated conservatorship or a bridge institution, with the bad assets liquidated while the remainder of the firm is ... re-privatised as soon as is feasible. ...

This plan has ... management and shareholders bear the costs for their actions before taxpayer funds are committed. This process also is equitable across all firms; is similar to what is currently done with smaller banks; and provides a definitive process that should reduce market uncertainty. ...

In contrast..., the current policy raises a host of issues:

● Certain companies have not been allowed to fail and, as a result, the moral hazard problem has substantially worsened. ...

● So-called “too big to fail” firms have been given a competitive advantage and, rather than being held accountable..., they have actually been subsidised in becoming more economically and politically powerful.

The US government has poured billions of dollars into these firms without a defined resolution process... The longer resolution is postponed, the greater the losses and the larger the debt burden.

● ...[T]he Federal Reserve is making loans directly to specific sectors of the economy, causing the Fed to allocate credit and take on a fiscal as well as a monetary policy role. This ... may compromise ... independence ... and make it more difficult to contain inflation in the years to come.

● ...We have entrenched these even larger, systemically important, “too big to fail” institutions into the economic system, assuring that past mistakes will be repeated.

Certainly, the approach I suggest for resolving these large firms also is not without substantial cost, but it looks to both the short and long run. ... While I agree that central banks must sometimes take actions affecting the short run, they must keep the long run in focus or risk failing their mission.

The fact that Citibank can negotiate the outcome of the stress tests is, I think, pretty good evidence that banks have become too big and too politically powerful for our collective good. (See here too.)

Monday, April 27, 2009

Paul Krugman: Money for Nothing

Will bankers escape new regulation and get off with "nothing more than a few stern speeches"?:

Money for Nothing, by Paul Krugman, Commentary, NY Times: ...Sanford Weill, the former chairman of Citigroup,... insisted that he and his peers in the financial sector had earned their immense wealth through their contributions to society.

Soon after..., the financial edifice Mr. Weill took credit for helping to build collapsed, inflicting immense collateral damage in the process. ... All of which explains why we should be disturbed by an article ... reporting that pay at investment banks ... is soaring again — right back up to 2007 levels.

Why is this disturbing?... First, there’s no longer any reason to believe that the wizards of Wall Street actually contribute anything positive to society, let alone enough to justify those humongous paychecks. ...

So why did some bankers suddenly begin making vast fortunes? It was, we were told, a reward for their creativity — for financial innovation. At this point, however, it’s hard to think of any major recent financial innovations that actually aided society, as opposed to being new, improved ways to blow bubbles, evade regulations and implement de facto Ponzi schemes.

Consider a recent speech by Ben Bernanke ... in which he tried to defend financial innovation. His examples ... were (1) credit cards — not exactly a new idea; (2) overdraft protection; and (3) subprime mortgages. (I am not making this up.) These were the things for which bankers got paid the big bucks?

Still, you might argue that ... it’s up to the private sector to decide how much its employees are worth. But this brings me to my second point: Wall Street is no longer, in any real sense, part of the private sector. It’s a ward of the state, every bit as dependent on government aid as recipients of Temporary Assistance for Needy Families, a k a “welfare.” ...[G]iven all that taxpayer money on the line, financial firms should be acting like public utilities, not returning to the practices and paychecks of 2007.

Furthermore, paying vast sums to wheeler-dealers isn’t just outrageous; it’s dangerous. Why, after all, did bankers take such huge risks? Because success — or even the temporary appearance of success — offered such gigantic rewards: even executives who blew up their companies could and did walk away with hundreds of millions. Now we’re seeing similar rewards offered to people who can play their risky games with federal backing. ...

Why are paychecks heading for the stratosphere again? Claims that firms have to pay these salaries to retain their best people aren’t plausible: with employment in the financial sector plunging, where are those people going to go?

No, the real reason financial firms are paying big again is simply because they can. They’re making money again (although not as much as they claim), and why not? After all, they can borrow cheaply, thanks to all those federal guarantees, and lend at much higher rates. So it’s eat, drink and be merry, for tomorrow you may be regulated.

Or maybe not. There’s a palpable sense in the financial press that the storm has passed: stocks are up, the economy’s nose-dive may be leveling off, and the Obama administration will probably let the bankers off with nothing more than a few stern speeches. Rightly or wrongly, the bankers seem to believe that a return to business as usual is just around the corner.

We can only hope that our leaders prove them wrong, and carry through with real reform. In 2008, overpaid bankers taking big risks with other people’s money brought the world economy to its knees. The last thing we need is to give them a chance to do it all over again.

Saturday, April 25, 2009

"Good Government and Animal Spirits"

Akerlof and Shiller say it's up to government to set animal spirits free, only then will they be maximally creative":

Good Government and Animal Spirits, by George A, Akerlof and Robert J. Shiller, Commentary, WSJ: The principal long-term result of the current financial crisis should be improved financial regulation. ...

An understanding of animal spirits -- the human psychology and culture at the heart of economic activity -- confirms the need for restoring the role of regulators... History -- including recent history -- shows that without regulation, animal spirits will drive economic activity to extremes. ...

At the end of the 1980s, our economic system was remarkably well-adapted to weather any storm. For example, massive numbers of S&Ls failed during the decade. But government protections isolated this collapse into a microeconomic event that, while it cost taxpayers quite a bit of money, only rarely cost them their jobs.

Then the economy changed -- as it always does -- challenging the regulations that were in place. ... And regulation did not adapt to reflect this change in the financial structure. The regulatory failure led to a profound systemic instability in our economy...

Public antipathy toward regulation supplied the underlying reason for this failure. The U.S. was deep into a new view of capitalism. Americans believed in a no-holds-barred interpretation of the game. We had forgotten the hard-earned lesson of the 1930s: Capitalism can give us real prosperity, but it does so only on a playing field where the government sets the rules and acts as a referee.

Contrary to a widespread impression the current situation is not really a crisis of capitalism. Rather we must recognize that capitalism must live within certain rules. ... It may be true that in the classical economic paradigm there is full employment. But with animal spirits, waves of optimism and pessimism cause large-scale changes in aggregate demand... When demand goes down, unemployment rises. It is the role of the government to mute those changes.

Moreover, entrepreneurs and companies do not just sell people what they really want. They also sell people what they think they want, and not infrequently what they think they want turns out to be snake oil. Especially in financial markets... All of these processes are driven by stories. The stories that people tell to themselves -- about themselves, about how others behave, and even about how the economy as a whole behaves -- all influence what they do. These stories vary over time.

Such a world of animal spirits justifies the economic intervention of government. Its role is not to harness animal spirits but really to set them free, to allow them to be maximally creative. A brilliant player wants a referee, for only when the game has appropriate rules can he really show his talents. ...American financial regulation hasn't had an overhaul in 70 years. The challenge for the Obama administration, along with the U.S. Congress and our SROs, is to invent a new and better American version of the capitalist game.

Wednesday, April 22, 2009

Using Anti-Trust Law to Break Up Banks that are Too Big to Fail

Simon Johnson wants to apply anti-trust laws to financial markets and use it to break up banks that are too big too fail. More vigorous enforcement of anti-trust laws is something I've been pushing here for a long time, and as I explain below I agree with this idea, but as I understand it, current anti-trust law is inadequate for this task (particularly on dimensions such as connectedness and systemic risk). So it will likely take Congressional action before we can proceed.

The reason for bringing this up is that I want to amend remarks I made in the past. I have said that there is no single villain in this crisis, no one person, not one change in the law, etc., that caused this. It was a combination of things. But as I think about it more and more, I'm not so sure. The reason? According to the story I've been telling about why the crisis happened, there were incentive failures at just about every step in  the process. Homeowners had no recourse loans giving them one way bets on home values, real estate agents are paid in a way that causes them to maximize the value of sales, mortgage brokers faced no long-run consequences from bad loans, real estate appraisers had incentives to validate sales, ratings agencies were paid by the people whose assets were being rated, CEOs and upper level management had incentives to maximize something other than shareholder value, there was a lack of transparency giving insiders an advantage, it goes on and on.There is not a single step in the process that wasn't compromised by an incentive or market failure of some type.

Looking at this at first, I concluded that it was all of these things, and more, that caused the crisis, and that it could have been stopped at any one of these steps. Had anyone at any one of the steps from the sale of the house to the complex securities traded in the shadow banking system said no, we're not doing that, the money could not have kept flowing through the system and blowing up the bubble. For example, if the mortgage brokers would have taken personal losses on mortgages that later went bad, they might have refused to finance them, and the money could not have been passed upwards to the shadow banking system where it caused such big problems. But instead, the brokers simply passed the contracts along, sliced and diced as necessary, to the next person in the finance chain.

But what should we make of the fact that every singe step in the process is compromised? Every market that was supposed to self-regulate failed? Does every single market in the chain fail at the same time through some highly unlikely coincidence? What are the chances that, on their own, independently, each and every step in the chain would have been subject to a market failure that just happened to let the bubble keep inflating? Whatever it took to keep the money flowing through the system seems to have come to pass.

So more and more I'm starting to thing there may be a single explanation after all, that the regulators of these markets were captured by powerful forces that wanted the game to continue. The power of regulators, and the will to enforce the regulations, must match - in fact exceed - the will and power of those being regulated to resist having constraints placed on their behavior. I've talked about why ideology may have eroded the will of regulators, but their will is partly a function of their power. So long as we allow huge, clearly over-sized financial institutions to exist, this problem will potentially be present.

Therefore, if the current anti-trust legislation is adequate to the task, then yes, let's give regulators the power to enforce it, and ensure we have people in place with the will to do so. But as I said above, I think current law may have glaring legal holes that need to be closed before we can use this section of the law effectively. If so, then it's time to get started crafting new legislation that is up to the task, and I hope Simon Johnson is successful in getting movement in this direction. He has my support.

Sachs: Paying for Government's Expanded Economic Role

Jeff Sachs says the government will need to find new sources of tax revenue:

The Costs of Expanding the Government's Economic Role [Extended version], by Jeffrey D. Sachs, Scientific American: The 10-year budget framework that President Barack Obama released ... is as much a philosophy of government as a fiscal action plan. Gone is the Ronald Reagan view that “government is not a solution to our problem; government is the problem.” Obama rightly sees an expanded role for government in allocating society’s resources as vital to meeting the 21st century challenge of sustainable development. 

The scientific discipline known as public economics describes why government is needed alongside markets to allocate resources. These reasons include: the protection of the poor through a social safety net; the correction of externalities...; the provision of “merit goods” such as health care and education that society deems to be essential for all of its members; and the financing of scientific and technological research that cannot be efficiently captured by private investors. In all these circumstances, the free-market system tends to underprovide the resource in question...

Obama’s budget plan properly focuses on areas that public economics identifies as priorities and where the U.S. discernibly lags behind many parts of Europe: health..., education..., public infrastructure... and research and development... The emphasis is on public-private partnerships (PPP), combining public financing and private sector delivery. ...

Obama’s vision of an expanded federal role is on-target and transformative, but the financing will be tricky. This year’s deficit will reach an astounding $1.75 trillion, or 12 percent of GDP...

Obama’s budget plan aims to reduce the deficit to 3 percent of GNP by 2013, and to level off till 2019..., but ... that target will be very difficult to achieve and sustain as planned. ...[T]he plan is to cut the deficit mainly through higher taxes on the rich, reduced military outlays for Iraq and Afghanistan, new revenues from auctioning carbon-emission permits and, finally, a squeeze on non-defense discretionary spending... Such a squeeze on non-defense spending seems unlikely—and indeed undesirable—at a time when government is launching several much-needed programs in education, health, energy and infrastructure.

The truth is that the U.S. ... will probably have to raise new revenues ... to carry out its vital roles in protecting the poor, promoting health and education and building a modern infrastructure with ... sustainable technology. Ending the Bush-era tax cuts on the rich certainly is merited, but further taxing the rich much beyond that will come up against political and practical limits. Within a few years, we’ll probably see the need for new broader-based taxes, perhaps a national sales or value-added tax such as those widely used in other high-income countries. If we continue to assume that we can have the expanded government that we need but without the tax revenues to pay for it, the unacceptable build-up of public debt will threaten the well-being of our children and our children’s children. ...

I doubt will see any major changes in the tax structure anytime soon, but if we do, value added taxes are regressive, but in countries where they are used, they're an important source of revenue for highly progressive tax-and-transfer systems (but not without problems). So the characteristic of these taxes overall depends upon their implementation, i.e. how the extra revenue from the tax is used.

Tuesday, April 21, 2009

"A Crisis of Ethic Proportions"

John Bogle says "self-interest got out of hand":

A Crisis of Ethic Proportions, by John Bogle, Commentary, WSJ: I recently received a letter from a Vanguard shareholder who described the global financial crisis as "a crisis of ethic proportions." Substituting "ethic" for "epic" is a fine turn of phrase, and it accurately places a heavy responsibility for the meltdown on a broad deterioration in traditional ethical standards. ... Relying on [the] "invisible hand," through which our self-interest advances the interests of society, we have depended on the marketplace and competition to create prosperity and well-being.

But self-interest got out of hand. ... Dollars became the coin of the new realm. Unchecked market forces overwhelmed traditional standards of professional conduct, developed over centuries. ... We've moved from a society in which "there are some things that one simply does not do" to one in which "if everyone else is doing it, I can too." Business ethics and professional standards were lost in the shuffle. ... The old notion of trusting and being trusted ... came to be seen as a quaint relic of an era long gone.

The proximate causes of the crisis are usually said to be easy credit, bankers' cavalier attitudes toward risk, "securitization"..., the extraordinary leverage built into the financial system by complex derivatives, and the failure of our regulators to do their job.

But the larger cause was our failure to recognize the sea change in the nature of capitalism that was occurring right before our eyes. That change was the growth of giant business corporations and giant financial institutions controlled not by their owners in the "ownership society" of yore, but by agents of the owners, which created an "agency society."

The managers of our public corporations came to place their interests ahead of the interests of their company's owners. ... The malfeasance and misjudgments by our corporate, financial and government leaders, declining ethical standards, and the failure of our new agency society reflect a failure of capitalism. ...

What's to be done? We must work to establish a "fiduciary society," where manager/agents entrusted with managing other people's money are required -- by federal statute -- to place front and center the interests of the owners they are duty-bound to serve. The focus needs to be on long-term investment (rather than short-term speculation), appropriate due diligence in security selection, and ensuring that corporations are run in the interest of their owners. ... Making that happen will be no easy task.

Rules will never cover everything, so ethics is part of the problem. But the solution to the agency problem has to come in large part from changing incentives so that the self-interest of the managers coincides with the interests of the people they represent. [Kahneman also talks about agency problems in a section I left out of the next post.]

Wednesday, April 08, 2009

Public Goods and Stimulus Packages

Two from Richard Green. First:

Adam Smith on Roads, by Richard Green: From Chapter 11 of the Wealth of Nations:

Good roads, canals, and navigable rivers, by diminishing the expense of carriage, put the remote parts of the country more nearly upon a level with those in the neighbourhood of the town. They are upon that account the greatest of all improvements. They encourage the cultivation of the remote, which must always be the most extensive circle of the country. They are advantageous to the town, by breaking down the monopoly of the country in its neighbourhood. They are advantageous even to that part of the country. Though they introduce some rival commodities into the old market, they open many new markets to its produce. Monopoly, besides, is a great enemy to good management, which can never be universally established but in consequence of that free and universal competition which forces everybody to have recourse to it for the sake of self-defence. It is not more than fifty years ago that some of the counties in the neighbourhood of London petitioned the Parliament against the extension of the turnpike roads into the remoter counties. Those remoter counties, they pretended, from the cheapness of labour, would be able to sell their grass and corn cheaper in the London market than themselves, and would thereby reduce their rents, and ruin their cultivation. Their rents, however, have risen, and their cultivation has been improved since that time.

Second, in response to Robert Lucas:

Two Questions about Macroeconomics, by Richard Green: I am not a macroeconomist. One of the reasons for this, I suppose, is that I was taught a lot of rational expectations overlapping generations stuff in graduate school and while I found it elegant, I did not believe it. The reason I didn't believe it is because the models are rejected by data: for instance, when households get short term changes in income, they seem to change their consumption behavior somewhat.

Nevertheless, there are ... macro issues that puzzle me. ...Ricardian equivalence types seem to have an underlying assumption that government can't invest in positive NPV opportunities. For instance, Robert Lucas argues that if the government borrows $100 million to build a bridge, household will know they have a future tax liability of $100 million, reduce their spending accordingly, and therefore offset the stimulative impact of the bridge.

But what if the cost to borrow for the bridge is 3 percent and the bridge's IRR is 5%? Then doesn't the bridge stimulate spending for the simple reason that it is a good investment? The federal government has made, it seems to me, some very good investments. Hoover Dam is one. Rural electrification is another. The interstate highway system. The Golden Gate Bridge. The New York City subway system. I could continue...

I do worry about bridges to nowhere. But many macroeconomists seem to believe in the hearts that public goods don't exist, and that there is nothing government can do better than the private sector. I think it is here that macro takes its cues more from religion than science.

[See also: Tax Cuts, Government Spending, Public Goods, and the Stimulus Package and Lucas: Monetary Policy Can Still be Effective.]

“Cap-and-Trade is a Tax"

Thomas Friedman says that opponents of policies to reduce the accumulation of greenhouse gases are going to point out that cap and trade is equivalent to a carbon tax, and make a political issue out of it, so why not go for the real thing?

Show Us the Ball, by Thomas Friedman, Commentary, NY Times: ...Last week, House Democrats, with administration support, introduced a 600-page draft bill ... to reduce greenhouse-gas emissions through a complicated cap-and-trade system. These people have the very best of intentions, but I wish they would step back and ask again: Can cap-and-trade pass? Will it really work? And is it the best strategy, with all the bureaucracy it will require to monitor, auction emissions permits and manage the trading?

Advocates of cap-and-trade argue that it is preferable to a simple carbon tax because it ... “hides the ball” — it doesn’t use the word “tax” — even though it amounts to one. ...

That was true as long as no one thought cap-and-trade could ever pass, but ... opponents are not playing hide the ball anymore. In the past two weeks, you could hear a chorus of Republicans, coal-state Democrats, right-wing think tanks and enviro-skeptics all singing the same tune: “Cap-and-trade is a tax. Obama is going to raise your taxes and sacrifice U.S. jobs to combat this global-warming charade... Worse, cap-and-trade will be managed by Wall Street. If you liked credit-default swaps, you’re going to love carbon-offset swaps.” ...

They could easily kill this effort. So, if the Obama team cares about ... a stronger America and a more livable planet,... I hope it will consider an alternative strategy, message and messenger.

STRATEGY Since the opponents of cap-and-trade are going to pillory it as a tax anyway, why not go for the real thing — a simple, transparent, economy-wide carbon tax? ...

People get that — and simplicity matters. Americans will be willing to pay a tax for their children to be less threatened, breathe cleaner air and live in a more sustainable world with a stronger America. They are much less likely to support a firm in London trading offsets from an electric bill in Boston with a derivatives firm in New York in order to help fund an aluminum smelter in Beijing, which is what cap-and-trade is all about. People won’t support what they can’t explain.

MESSAGE Climate change is a real threat to a healthy planet... But because the worst effects are in the future, many Americans have more immediate concerns. That is why our energy policy should be focused around “American renewal,” not mitigating climate change.

We need a price on carbon because it will stimulate massive innovation in ... energy technology. ... I.T. could be the foundation for a second American industrial revolution, plus it would tip the whole planet onto a greener path. So American economic renewal is the goal, but mitigating climate change would be the great byproduct.

MESSENGER The Obama administration’s carbon tax spokesman — the one who should sell this to the country — should be the president’s national security adviser, Gen. James Jones, not the environmentalists. The imposing former head of the Marine Corps could make a powerful case that ... the country with the most powerful clean-technology industry in the 21st century will have the most energy security, national security, economic security, healthy environment, innovative companies and global respect. That country must be America. So let’s stop hiding the ball and have a strategy, message and messenger that tell it like it is — and make it so.

The tax changes can be made revenue neutral so that there is a change in the incentive to consume goods with high carbon content, but no change (implicit or explicit) in the overall tax burden (e.g. see here for a carbon tax example - a cap and trade equivalent exists). In addition, such rebates, if properly distributed, could help with the political problem Friedman is worried about.

Thursday, April 02, 2009

Using Markets to Fix Markets

Robert Stavins on the "enlightened use of markets" to make fisheries sustainable:

Using Markets to Make Fisheries Sustainable, Robert Stavins: Around the world, over-fishing is leading to severe depletion of valuable fisheries. ... According to the United Nations Environment Program, fully 25 percent of fisheries worldwide are in jeopardy of collapse due to over-fishing. Clearly, something needs to be done. Yet, what has long been considered the obvious answer - restrictions on fishing - has been shown time and time again to be the wrong answer. The right answer is enlightened use of markets.

The fundamental cause of the depletion of fish stocks is well known to economists: virtually all ocean fisheries are “open-access,” that is, fishermen - small operations or large corporations - can fish all they want. ... Each fisherman receives the full benefit of aggressive fishing (that is, a larger catch), but none pay the full cost (an imperiled fishery for everyone). One fisherman’s choices have an effect on other fishermen (of this generation and the next), but in an open-access fishery ... these impacts are not taken into account. What is individually rational adds up to collective foolishness, as the shared resource is over-exploited. This is the “tragedy of the commons.” What to do?

Government intervention is, alas, required. Fishermen don’t welcome such regulation in their economic sphere any more than anyone else does. And they have a point. Conventional regulatory approaches have driven up costs, but not solved the problem. And we know why. If the government limits the season, fishermen put out more boats. If the government limits net size, fishermen use more labor or buy more costly sonar. Economists call this over-capitalization. Costs go up for fishermen (as resources are squandered), but pressure on fish stocks is not relieved.

The answer is to adopt in fisheries management the same type of innovative policy that has been used for decades in the realm of pollution control - tradeable permits, called “Individual Transferable Quotas” ( ITQs) in the fisheries realm. Sixteen countries - some with economies much more dependent than ours on fishing - have adopted such systems with great success. New Zealand regulates virtually its entire commercial fishery this way. It’s had the system in place since 1986, and it’s been a great success, putting a brake on over-fishing and restoring stocks to sustainable levels ­- while increasing fishermen’s profitability!

There are several ITQ systems already in operation in the United States, including for Alaska’s pacific halibut and Virginia’s striped-bass fisheries. More important, the time is ripe for broader adoption of this innovative approach, because a short-sighted ban imposed by the U.S. Congress on the establishment of new ITQ systems has expired.

The first step in establishing an ITQ system is to establish the “total allowable catch.” The next step - and a crucial one - is to allocate shares of that total limit to fishermen in individual quotas that are theirs and theirs alone (read: well-defined property rights). Setting the individual quotas will not be easy. The guiding principle should be simple pragmatism - using the allocations to build political support for the system. Making the quotas transferable eliminates the problem of overcapitalization and increases efficiency, because the least efficient fishing operations find it more profitable to sell their quotas than to exploit them through continued fishing. If you can’t catch your whole share, you can sell part of your quota to someone else, instead of buying a bigger boat.

In addition, these systems improve safety by reducing incentives for fishermen to go out (or stay out) when weather conditions are dangerous. ... Further, because ITQ systems eliminate the motivation for government to limit the duration of the fishing season, supplies available to consumers improve in quality. Prior to the establishment of an ITQ system for Alaskan halibut, for example, the government had reduced the fishing season to just two days, but subsequent to the introduction of the system, the season length grew to more than 200 days.

A decade ago, environmental advocates - led by the Environmental Defense Fund - played a central role in the adoption of the sulfur dioxide allowance trading program that’s cut acid rain by half and saved electricity generators and rate-payers nearly $1 billion annually, compared with conventional approaches. The time has come for environmentalists to join forces with progressive voices in the fishing industry and in government to set up ITQ systems that can keep fishermen in business while moving fisheries onto sustainable paths.

The allocation of individual shares is, as noted above, crucial, and the danger in having the government set the individual quotas is that "pragmatism" and the desire to "build political support" will lead to political favoritism in the allocations, that large firms will have an advantage in capturing the quota regulators, etc. For these reasons, and others, it seems like an auction mechanism would work better, at least for the initial allocation, but perhaps there are political objections to auctions that preclude this option (though the fact that such strong political forces exist would argue for a market based allocation mechanism even though those same forces would prevent such a mechanism from being implemented).

Friday, March 27, 2009

Why Did Ratings Agencies Fail?

The failure of ratings agencies to properly price the risky securities at the heart of the financial crisis has been attributed to conflict of interest (being paid by the issuers of the assets they are rating) and shopping for the best rating (get more than one rating, then only make public the highest one). However, an objection to these explanations is that these incentives have always existed, yet the problems did not emerge until recently. Thus, any explanation relying upon these incentives must explain why they did not cause problems until recently.

This article says the answer can be found in the complexity of the assets that are being rated. When the assets are very simple, risk assessment is not very complicated and the dispersion of ratings across agencies is very low. Thus, there is no incentive to shop around. In addition, it is hard for the agencies to become beholden to asset issuers and inflate ratings because such behavior would be transparent enough so as to risk losing credibility. That is, people outside the agencies can independently check and verify the ratings easily so any manipulation of the ratings would be easy to discover, and the revelation that their ratings are inflated would damage their credibility and hence their business.

But all of this changes when the assets become more complex. First, because of the complexity the dispersion of ratings across agencies will increase. Thus, even if the mean rating does not change, the variance of the ratings make it worthwhile to pay for more than one rating and cherry pick the best of the lot, i.e. to shop around. (In numerical terms, suppose assets are rated from 1, which is the highest risk category, to 10 which is the safest. A non-complex asset might have a dispersion of, say, 7.95 to 8.05 among a fixed number of ratings agencies, while a complex asset might have ratings running from 6.50 to 9.50. In both cases, assuming a symmetric distribution, the mean is 8, but the rewards to shopping around are quite different).

Second, it is easier for the issuer to capture the rating agency, i.e. for the agency to produce the ratings the company is looking for, because the complexity makes such behavior harder to uncover. The ability of outside observers to uncover such behavior diminishes when the variance of the ratings goes up.

To be more precise about the incentive to shop around, there is a cost to obtaining one more rating, the fee the firm must pay (though the article below implies the firm can escape the fee it if doesn't like the rating it gets). The benefit is the chance that the new, incremental rating will be higher than the ratings already in hand, and this diminishes as more ratings are collected, i.e. there is a declining marginal benefit. If the fee is relatively low, it will be worthwhile to collect many ratings, and the expected rating outcome - the maximum of the ratings - will be higher as more ratings are collected. However, issuers do not necessarily collect ratings from every ratings firm since the expected benefit of an additional rating may not cover the cost. But if the fees are sufficiently low, if the assets are sufficiently complex, and if the number of firms is sufficiently small - a case that may describe the recent market fairly well - a corner solution will emerge, i.e. it always pays - in expected terms - to collect all the ratings available and then make only the best rating public.

The other side of this, though, is that the degree of distortion falls when the number of ratings agencies is small. That is, the expected maximum rating is increasing in the number of ratings collected (though the increase comes at a decreasing rate, that's why there is a declining marginal benefit to collecting another rating). It depends upon the nature of the underlying distributions, but it's possible - and I think likely - that the distortion from this factor was low due to the fact that there were only, effectively, Moody and Standard & Poor operating in these markets (do we count Fitch too?). If so, if the shopping around distortion is relatively minor because the number of firms is small (and that is highly speculative on my part, and based upon the quick reactions scribbled out above rather than days of careful thought), then the alternative explanation that the ratings agencies were beholden to asset issuers should be given more weight as the likely, predominant explanation for the problems in these markets.

In any case, here's the article:

The origin of bias in credit ratings, by Vasiliki Skreta and Laura Veldkamp, Most market observers attribute the recent credit crunch to a confluence of factors – excess leverage, opacity, improperly estimated correlation between bundled assets, lax screening by mortgage originators, and market-distorting regulations. Credit rating agencies were supposed to create transparency, provide the basis for risk-management regulation, and discipline mortgage lenders and the creators of structured financial products by rating their assets. Understanding the origins of the crisis requires, at least in part, understanding the failures of the market for ratings. Proposed explanations for ratings bias have broadly fallen into three categories.

Continue reading "Why Did Ratings Agencies Fail?" »

Monday, March 23, 2009

"Toxic Car" Follow-Up: Pricing Toxic Assets

Sandro Brusco at noiseFromAmeriKa, a blog with other Italian economists Alberto Bisin, Michele Boldrin, Gianluca Clementi, Andrea Moro and Giorgio Topa, sent this to me in response to the post on toxic cars. One of the key problems in the example, and in the toxic asset problem more generally, is finding the right price for the assets when there is no market for them. Sandro uses an example similar to the "toxic car" example to show how mechanism design theory can be applied to the problem of evaluating toxic assets:

Mechanism Desing and the Bailout: Introduction Since the explosion of the banking crisis we have seen many analyses and many proposals for solution; hardly a day seems to pass by without the appearance of a new plan to save the banks. So, you may ask, why do we need plan n+1? Well, I am not going to propose a full-fledged plan. Rather, I would like to make a partial proposal related to one aspect of the problem, the evaluation of the so-called ''toxic assets''. The theoretical underpinnings of many of the existing proposals are often quite opaque: I would like to do the opposite, so I will try to explain in some detail the theoretical basis of my proposal.

Continue reading ""Toxic Car" Follow-Up: Pricing Toxic Assets" »

Sunday, March 22, 2009

Government Intervention in the Market for Toxic Cars

Imagine a car lot that has 100 cars on it. However, some of these cars have problems. Half of them will have engine troubles that total the cars - the engines blow up and the cars are then worthless - and this will happen just after purchase. The other half are perfectly fine. Unfortunately, there is no way to tell prior to purchase which type of car you will get no matter how hard you try. Thus, half of the assets on the car dealer's "balance sheet" - the cars on its lot - are toxic, and lack of transparency makes it impossible to tell which ones are bad prior to purchase.

If all the cars were in perfect shape, they would sell for $20,000 each. Thus, there are (50)*($20,000) = $1,000,000 in assets on the books according to one way of doing the accounting, but that doesn't necessarily represent the true value of the cars on the lot.

The town where this dealership is located relies upon this business for jobs, it is essential, but, unfortunately, business has fallen off to nothing. Nobody is willing to risk losing $20,000 by purchasing a car that might die just after purchase, so the price has fallen. The expected value of a car is $10,000, but it's an all or nothing proposition, the car runs or it dies, and since people are risk averse nobody is wiling to pay the $10,000 expected value. In fact, the highest price they are willing to pay, $6,000, is lower than the minimum price the dealer is willing to accept (I've assumed a reservation price of $7,500 for illustration, and a horizontal supply curve to make the illustration easier):

So how could the government fix the problem?

1. Government purchases of toxic cars

The government could buy the cars itself, say at $7,500 per car, or $750,000 total for the lot, drive them around a bit (stress test them), wait for the bad ones to blow up, then sell the 50 good cars back to the public (who will no longer be fearful since the bad cars are out of the mix). If they can get anything more than $15,000 for each good car, they will make money on the deal (well, there would be overhead and other costs to cover, but let's abstract from minor details). But if cars end up selling for less than $15,000, they will take a loss.

(In the graph, the government intervention shifts the demand curve outward until it intersects at the kink in the supply curve at Q=100).

The problem with this option is knowing what price to offer for the cars. There is no market, and the firm's reservation price may be too high, i.e. paying the reservation price will eventually lead to a loss. And it's worse. In this example the percentage of bad cars is known, but the percentage of bad cars would also be unknown in a more realistic example, so there's no way to know how many good cars there are for sure, and what price they will sell for after the defective cars have been culled out of the herd. If the government pays $7,500 per car, and more than 62.5% of them go bad (not that much more than the 50% estimate), then taxpayers will lose money even if they sell for $20,000. With the percentage unknown, there's no way to know for sure what the breakeven price will be.

This is, in essence, the original Paulson plan. The only twist is that the price - the $7,500 in the example above, would be determined by an auction among many dealers with the government accepting the lowest bid (which could be $7,500 in this example since that is the price the firm is willing to accept). As you can see by thinking this through, there are questions about what price such an auction would reveal.

One danger in this plan is that if you overpay for the cars, e.g. give $7,500 when the breakeven price was, say, actually $5,000, then you have given the owner of the car lot $250,000 more than the cars were actually worth (this will be the loss to taxpayers). The dealer may need this money to stay solvent and stay in business, but, nevertheless, it is a windfall.

There are a lot of uncertainties here, and lots of ways to lose money. But it's possible to make money too.

2. Subsidies and Public-Private partnerships

Here, the government offers a subsidy to private sector buyers. Suppose that the demand curve intersects the vertical line in the graph (at Q=100) at a price of $4,000. Then in order to sell 100 cars, the government must subsidize buyers by $3,500 so that the $4,000 offer is raised to the $7,500 the firm is willing to accept (notice that the buyer willing to pay $6,000 gets a $2,000 windfall, so, except at the margin, this plan gives surplus to people purchasing the assets - as with the first plan, this shifts the demand curve out until it intersects at the kink in the supply curve).


However, once again, the government will not know if it is getting this right or not. Suppose it offers a $1,000 subsidy thinking that is generous enough. In this example, that won't bridge the gap between the highest offer of $6,000, and the reservation price of $7,500. Thus, the subsidy would be too small to restart the market and the plan would fail. So the answer is to make the subsidy large enough to encourage buyers, but the problem is that if it is too large, the government will be giving money away unnecessarily.

And there's another problem. If there's a large gap between what people are willing to pay and what dealers are willing to accept(the gap between $6,000 and $7,500 in the example), this would be problematic politically since it would require subsidies that are unacceptably large.

And I should note that it doesn't have to be a subsidy. That's one way to do this - as a giveaway - but another way is through a no recourse loan (what is being called a partnership). Suppose that the government gives (up to) a $3,500 loan to a private sector buyer to purchase the car for $7,500. If it's a good car and the value rises above $7,500, say to $15,000, then government will get paid back (with interest) since the asset can be sold profitably (another option is for the government to demand a share of this profit through warrants or other means). But if it's a bad car, the price falls to zero and the loan is forgiven - it does not need to be repaid. So the private sector agents only have to put up a fraction of the price to control the asset, and their losses are limited to the amount they put up while the gains are potentially large.

This is, in essence, the Geithner Plan. If many of the loans are not repaid, or if the subsidy is too large, it could lose a lot of money, but it could also make money too.

3. Nationalization

Now for the Saab story. Another option is for the government to simply take over the car dealership. The dealership is essential to the economy of the town, without it people will struggle, and the government - for that reason - might consider temporarily taking over the dealership to prevent failure. In doing so, it would make an evaluation of the company's assets, pay off the people who loaned the business money up to this amount, which may require having them take a haircut, i.e. accept some percentage of what they are owed on the bad loans they made, and the owner would simply be wiped out (which is a benefit since the business is insolvent and this allows the owner to escape the loans that cannot be paid through liquidation).

After taking over, the government would stress test the cars it now owns, put the bad ones in the junk pile, and sell the rest back to the public. So long as it didn't pay the creditors too much when it took over, i.e. the haircut is sufficiently large, it ought to make money on the deal. But it could lose money here too.

The Point

But, and I want to stress this, the point of these plans is not to make money, the point is to keep the economy of the town going, to keep people employed. If people place a large value on security, then even if the government takes a loss on paper, it may not be an economic loss. That is, we must put a value on the jobs that are saved and the security it brings (simply imagine that the utility function has risk as one of its arguments - by lowering the risk of job loss and the associated household disruption, you have made the agent better off, and this must be counted against any loss from any of the programs above). There is value in economic stability and security over and above whatever the government makes (or loses) on the actual financial transactions, and this must be factored into the evaluation of the policy.

Thursday, March 19, 2009

"The Judgments of the Market are True and Righteous Altogether"

Christopher Carroll with an evidence based rebuttal to the "risk-is-holy view" advocating a free market, hands off approach to the financial crisis, and a call for the Fed to do what it always does in a crisis, manage the price of risk (which means going beyond measures such as the purchase of long-term government securities and taking risky assets onto the Fed's balance sheet):

Punter of last resort, Christopher D. Carroll, Vox EU: The financial meltdown that shifted into high gear last September has flushed into public view many surprising facts. One of the strangest is the existence, in the economics profession, of a bizarre religious cult. This cult adheres to the dogma that the “price of risk” is the Holy of Holies that can properly be set only by the immaculate invisible hand of the financial marketplace; and cult members seem to believe, to paraphrase President Lincoln from a rather different context, that “If the Market wills that the economic crisis continue until every dollar of economic activity created by the taking of risk shall be repaid by another dollar destroyed by a newfound fear of risk, so it still must be said that the judgments of the Market are true and righteous altogether.”

The deep origins of the cult, as always, are obscure; presumably they lie properly in the field of psychoanalysis. But to the extent that overt origins can be traced, the wellspring is the literature that attempts to explain the Mehra and Prescott (1985) ‘equity premium puzzle.’ The ‘puzzle,’ in a nutshell, is that asset prices have not, historically, exhibited a relationship between risk and return that is easy to reconcile with the rational behavior of a representative agent facing perfect markets. Many of the responses to this challenge start with the assumption that asset prices must be always and everywhere rational, and then proceed to work out the kind of preferences or environment that can rationalize observed prices. This game brings to mind Joan Robinson’s comment that “utility maximization is a metaphysical concept of impregnable circularity,” and Larry Summers’s remark (quoted by Robert Waldmann) that the day when economists first started to think that asset prices should be explained by the characteristics of a representative agent’s utility function was not a particularly good day for economic science. Oddly, even the failure of this literature to produce a widely agreed solution to the ‘puzzle’ does not seem to have weakened participants’ belief in the soundness of the intellectual framework within which asset prices are a puzzle.

Nor does the assumption that asset prices are always and everywhere perfect reflect the actual past practice of economic policymaking during crises. As DeLong (2008) has recently reminded those of us who are susceptible to the lessons of history (see also Kindleberger (2005)), the “lender of last resort” role of the central bank has always been, during a panic, to short-circuit the catastrophic economic effects of a collapse of financial confidence (in today’s terminology, ‘an increase in the price of risk’).1

Some economists, of course, view narrative history in the DeLong and Kindleberger mode as irrelevant to the practice of their science; they prefer hard numbers to mere narrative. For the numerically inclined, however, Figures 1a and 1b should be persuasive; they show that controlling a market price of risk is something the Federal Reserve has done since it first opened up shop. The top figure depicts a measure of what we are now pleased to call the ‘risk-free’ rate of interest in the United States – essentially, the shortest-term interbank lending rate for which data are available (on a consistent basis) from before and after the founding of the Fed.2 Figure 1b shows the month-to-month changes in this interest rate. The only reason this rate is now viewed as ‘risk-free’ is that the Fed takes away the risk.3

Figure 1a

Figure 1b

Do the advocates of the risk-is-holy view really believe that we were better off in a real free-market era when interbank rates could move from 4 percent to 60 percent from one month to the next (as happened in 1873)? And how long do they think such a system would last? It was, after all, the intolerable stresses caused by financial panics that ultimately led to the founding of the Federal Reserve, in the face of adamant opposition from people holding financial-markets-are-perfect, believe-me-not-your-lying-eyes views that are eerily similar to dogmas that continue to be propounded today. The panic of 1907, in which J.P. Morgan effectively stepped in as a private lender of last resort, constituted the last straw for the unregulated financial system that preceded the managing of risky rates that we have had since the creation of the Fed.

A less extreme version of essentially the same dogma states that while it is acceptable for the central bank to suppress the aggregate risk that would otherwise roil short-term interest rates, the Fed should ignore all other manifestations of financial risk. It is, if anything, harder to construct a coherent economic justification of this point of view than of the strict destructionist view that says the Fed should not exist at all. But there is, at least, a perception that this way of operating is hallowed by time and practice: Since the Fed, the story goes, has spent most of its history ignoring risk, it shouldn’t change that now.

But even this milder dogma does not match the facts. Recent work by Robert Barbera, Charles Weise, and David Krisch,4 shows that over the “Taylor Rule” era of systematic monetary policy (roughly since 1984), the Federal Reserve’s choice of the short run interest rate has been powerfully correlated to market-based measures of risk such as the difference between the interest rates on corporate bonds and corresponding maturity Treasuries. When risk has been high, the Fed has felt the need to stimulate the economy by cutting short-term rates, and vice-versa.

Given the Fed’s pattern of past responses to risk and economic conditions (as embodied in risk-augmented Taylor rules), the implied value of the short term interest rate right now should be somewhere below negative 3.3 percent (actually even lower, since these projections do not reflect the dire recent news). Since interest rates cannot go below zero, the Fed must do something else to boost the economy. The obvious answer is to do everything possible to rekindle the appetite for risk – even if that means taking some of that risk onto the Fed’s balance sheet. This could be accomplished under some interpretations of the still-evolving Term Asset Lending Facility and has already happened in the case of some other, bolder, Fed actions that have been properly viewed as necessary to prevent financial collapse (Bear Stearns; the takeover of the commercial paper market). How much to buy, and which assets to buy, and how to minimize the political risks, are all difficult questions. But the danger of doing too little is far greater, at present, than the danger of doing too much.

The voices that say the Fed should do nothing at all, or nothing beyond perhaps some purchases of longer-dated Treasury securities, are not the voices of reason; they represent a howling dogma that was discredited in 1844 (when the Bank of England received its first implicit authority to intervene during panics; see DeLong (2008)), was discredited again in the panic of 1907, and again during the Great Depression (by being adopted in an extreme form), and is in the process of being discredited yet again today. (In fairness, during ordinary times it is probably wise for the authorities to avoid attempting systematic manipulation of the price of risk, for all the reasons Kindleberger (2005) and Robert Peel (1844) articulated. But this is no ordinary time).

Let’s put it this way: Simple calculations show that the current price of risk as measured by corporate bond spreads amounts to a forecast that about 40 percent of corporate America will be in bond default in the near future.5 The only circumstance under which this is remotely plausible is if government officials turn these dire forecasts into a self-fulfilling prophecy by failing to intervene forcefully in a way that quells the existential terror currently afflicting the markets. While I realize that some economists (and some politicians) might be willing even to undergo another Great Depression as the steep price of clinging to their faith, those of us who do not share that faith should not have to suffer such appalling consequences.

As the Economist magazine might put it, the problem is that the ‘punters’ (investors) who normally populate the financial marketplace and risk their fortunes for the prospect of return, have fled from the field in terror. Back when the financial system was almost entirely based on banks, the solution to such a problem was that the Federal Reserve would act as the ‘lender of last resort’ to quell the panic. In the new financial system where banks are a much smaller share of the financial marketplace than they once were, the Fed’s appropriate new role seems clear: It needs to intervene more broadly than before, in public markets (as has already been done for the commercial paper market) as well as for banks; it needs, in other words, to step up to the plate and become the punter of last resort.


Continue reading ""The Judgments of the Market are True and Righteous Altogether"" »

Wednesday, March 11, 2009

Greenspan: The Fed Didn't Do It

Alan Greenspan takes on John Taylor's claim that the Fed caused the housing bubble, and he warns against "micromanagement by government" regulators. Greenspan says the Fed couldn't have caused the housing bubble because it lost control over long-term interest rates once financial markets became globalized, and those were the rates that caused the problem:

The Fed Didn't Cause the Housing Bubble, by Alan Greenspan, Commentary, WSJ: ...The Federal Reserve became acutely aware of the disconnect between monetary policy and mortgage rates when the latter failed to respond as expected to the Fed tightening in mid-2004. Moreover, the data show that home mortgage rates had become gradually decoupled from monetary policy even earlier...

[T]he presumptive cause of the world-wide decline in long-term rates was the ... surge in growth in China and a large number of other emerging market economies that led to an excess of global ... savings... That ... propelled global long-term interest rates progressively lower between early 2000 and 2005.

That decline in long-term interest rates across a wide spectrum of countries statistically explains, and is the most likely major cause of ... the global housing price bubble. ... I would have thought that ... such evidence would lead to wide support for ... a global explanation of the current crisis.

However, starting in mid-2007, history began to be rewritten, in large part by ... John Taylor... Mr. Taylor unequivocally claimed that had the Federal Reserve from 2003-2005 kept short-term interest rates at the levels implied by his "Taylor Rule," "it would have prevented this housing boom and bust." This notion has ... taken on the aura of conventional wisdom.

Aside from the inappropriate use of short-term rates to explain the value of long-term assets, his statistical ... analysis carries empirical relationships of earlier decades into the most recent period where they no longer apply.

Moreover,... the "Taylor Rule" ... parameters and predictions derive from model structures that have been consistently unable to anticipate the onset of recessions or financial crises. Counterfactuals from such flawed structures cannot form the sole basis for successful policy analysis or advice, with or without the benefit of hindsight. Given the decoupling of monetary policy from long-term mortgage rates,... the Fed ... could not have "prevented" the housing bubble. ...

It is now very clear that the levels of complexity to which market practitioners at the height of their euphoria tried to push risk-management techniques and products were too much for even the most sophisticated market players to handle properly and prudently.

However, the appropriate policy response is not ... heavy regulation. That would stifle important advances in finance that enhance standards of living. ... The solutions for the financial-market failures ... are higher capital requirements and a wider prosecution of fraud -- not increased micromanagement by government entities. ... Adequate capital and collateral requirements ... will not be overly intrusive, and thus will not interfere unduly in private-sector business decisions.

If we are to retain a dynamic world economy capable of producing prosperity and future sustainable growth, we cannot rely on governments to intermediate saving and investment flows. Our challenge in the months ahead will be to install a regulatory regime that will ensure responsible risk management..., while encouraging them to continue taking the risks necessary and inherent in any successful market economy.

We seem to have a disagreement on the scope of regulation. Ben Bernanke:

Bernanke Calls for Broader Regulations, WSJ: Federal Reserve Chairman Ben Bernanke said regulators should be given broad new powers to oversee financial markets... Among his recommendations were tougher capital requirements for big banks, limits on investments by money-market mutual funds, and the introduction of some mechanism that would allow the U.S. to wind down big financial institutions and possibly run them temporarily. ...

The recommendations were largely consistent with measures being pushed by House Financial Services Committee Chairman Barney Frank (D., Mass.), who is expected to be a key architect of the new financial regulation. ...

Mr. Bernanke ... also pushed for much tougher policies over ... big companies. "Any firm whose failure would pose a systemic risk must receive especially close supervisory oversight of its risk-taking, risk management and financial condition, and be held to high capital and liquidity standards," Mr. Bernanke said. ...

I'm in agreement with Greenspan's response to Taylor to the extent that following the Taylor rule wouldn't have stopped the crisis, but I think the low interest rate policy pursued by the Fed is part of the story and served to magnify other factors. As for regulation, relying mainly upon enhanced capital requirements as Greenspan proposes isn't enough, so I'm at least where Bernanke with respect to close supervisory oversight of firms who pose a systemic risk. But I'd go even further and - to the extent possible - break up the firms into smaller entities and sever their interconnections until they no longer posed a threat to begin with. This is harder than it sounds, or so I'm told, but I'd still pursue the option.