Category Archive for: Market Failure [Return to Main]

Saturday, October 09, 2010

Moral Hazard in the Shadow Banking System

Due to the push by the administration to defend TARP (e.g. see Tim Geither's "five myths about TARP" here), there is lots of discussion about the moral hazard problems the bailout created. For example, Ryan Avent says:

Just last month I responded to the wave of praise for TARP ... by pointing out that whether or not TARP cost the Treasury much money, it left a giant moral hazard problem hanging out there, which has not yet been resolved.

Not everyone would agree that recent Dodd-Frank legislation fails to address moral hazard, though as I'll explain below I tend to agree with Ryan.

Let's take a stylized look at moral hazard, and how to overcome it. This is from a paper by Morgan Ricks (that I hope to present in more detail soon). The moral hazard problem was created by "ex-post support" that firms were given, and the paper details this support:

In response to the crisis, the government expanded the banking safety net dramatically to cover shadow banking. Indeed, at the height of the crisis, the overwhelming objective of the government’s emergency policy response was to halt the spreading panic by short-term creditors of shadow banking firms. It is useful to recount these policy measures briefly to portray their awesome scale:

  • The Federal Reserve provided secured lending to non-bank, repo-funded securities dealers through the Primary Dealer Credit Facility ($150bn)
  • The Federal Reserve financed dealer purchases of unsecured and asset-backed commercial paper through through the Commercial Paper Funding Facility ($350bn)
  • The Federal Reserve gave indirect discount window access to money market funds by financing banks’ purchases of ABCP through the Asset-Backed Commercial Paper Money Market Mutual Fund Liquidity Facility ($150bn)
  • The Federal Reserve provided collateral substitution for dealers, facilitating their access to the repo markets, through the Term Securities Lending Facility ($230bn)
  • The Federal Reserve extended credit to AIG ($90bn), allowing it to meet near-term contractual obligations
  • The Federal Reserve created the Maiden Lane programs to finance certain assets of AIG and Bear Stearns ($70bn)
  •  The FDIC guaranteed senior debt issued by financial firms, including diversified financial groups with distressed dealer operations ($340bn)
  •  The FDIC issued an unlimited guarantee of uninsured transaction account deposits ($700bn)
  •  The Federal Reserve, the FDIC, and the Treasury Department provided an asset wrap for Citigroup to stabilize its uninsured funding base ($260bn)
  •  Treasury supplied capital infusions through TARP ($250bn), which were primarily directed toward stabilizing firms with uninsured wholesale liabilities
  •  Treasury supplied a guarantee of the money market mutual fund industry ($3,200bn)

The stated purpose of these policy interventions was not to protect shadow banking for its own sake. Rather, it was to avoid the externalities of panics—the prospect of a prolonged disruption in the credit delivery system and a consequent reduction in commercial activity (which depends vitally on credit). Naturally, however, these interventions have been subject to criticism on grounds of moral hazard: The use of these tools creates the expectation that they may be used again. And moral hazard gives rise to costly subsidies and resource misallocation.

The moral hazard problem that resulted from this support can be illustrated with a modified diagram from the Morgan Ricks paper:

Ricks In this diagram, the MC curve is the cost of funds to the maturity transformation firm (i.e. shadow bank). The distance between the MC curve and the risk-free interest rate, Rf, represents the risk premium the firm must pay for its funds. For simplicity, it is assumed that the cost of funds is constant as Q increases (but that can easily be relaxed).

The MR curve shows the amount the firm earns using the borrowed funds (it pays MC for these funds). It is downward sloping because the firm invests in the highest return investment first, the next highest second, and so on. The efficient equilibrium is where the solid lines intersect, and the profit/surplus at the efficient outcome is the gray shaded area.

Moral hazard has two effects. First, it shifts the MR curve outward and the MC inward, as explained in the paper:

Moral hazard results in a rightward shift in the marginal revenue curve: The possibility of ex post support increases the profitability of the firm’s existing investments (by permitting it to extract value by reducing the capital held against those investments) and presents the firm with additional (and previously unprofitable) investment opportunities in riskier assets. Moral hazard also shifts the marginal cost curve upward, since riskier firms are more likely to default.

The result is an inefficient outcome (Q' is greater than Q at the intersection of the dashed lines), along with too much risk.

The solution to the moral hazard problem is, then, to shift the MR curve back where it started. And, if the MR curve shifts back, risk will fall, and the MC will shift back as well.

One way to do this is through ex-ante constraints. By restricting the actions the firm can take ex-ante, the MR curve shifts down and, as risk falls because of the restrictions, the MC shifts down along with it. If the constraints are calibrated just right, the problem can be fully eliminated and the firm will return to the efficient outcome.

The imposition of ex-ante constraints such as capital requirements, activity restrictions, and supervision mimics what is done in traditional insurance markets to overcome the moral hazard problem. In particular, a common requirement is that the firm hold a certain amount of capital, and that this capital must absorb the first loss. This is exactly like a deductible that must absorb the first loss in auto, health, fire, and other insurance markets -- when combined with a risk based premium, it's the standard solution to the moral hazard problem.

In the traditional banking system, firms are required to hold capital that is "impaired" should the resolution process be triggered, and they pay risk based fees to the FDIC. Thus, the traditional banking system mimics the standard response to moral hazard in insurance markets generally (and the deposit insurance, fees, capital impairment, activity restrictions, and regulation have all but eliminated runs in the traditional system while minimizing moral hazard).

But in the shadow banking system, when the crisis hit there was no legal way to impair capital. That is, there was no legal authority to force firms into the resolution process, and then force capital holders to take the first loss. Thus, if regulators wanted capital holders to face market discipline, their only choice was to let firms fail. They tried that with Lehman and it didn't works so well -- the outcome was a run on the shadow banking system (stopping these runs with an insurance regime along the lines of the FDIC is the point of the Morgan Ricks paper). The other choice was to bail the too big to fail firms out with all the negatives that come with that decision (both political and economic). Given those two choices, I think regulators made the right decision.

But they should not have been forced into just these two options, and Dodd-Frank tries to fix that. With the passage of Dodd-Frank, regulators now have the authority to impair capital in the resolution process, and that should help with the moral hazard problem. However, the current regulations do not eliminate the chance of a run on the shadow banking system, that danger is still present. If this happens, an important question is whether regulators will have the courage to put the next Lehman through the resolution process. If they suddenly get cold feet and decide to go back to what they know works -- a bailout -- rather than trying something new that may or may not work better -- resolution with capital impairment, etc. -- then the ex-post support detailed above, or something similar, will reappear and moral hazard is still present.

So is moral hazard eliminated? I am not convinced that regulators will, in fact, put a systemically important firm through resolution in the heat of the battle. To the extent that participants in financial markets share that belief, moral hazard has not been eliminated. I believe that so long as the chance of a significant bank run remains, this will be a problem.

So the key is to reduce the chance of a run in the shadow system to near zero (as we have done in traditional banking). We know from Diamond-Dybvig (1983) that any firms that does maturity transformation is subject to runs, and that an insurance regime is the only way to eliminate this possibility. Thus, a solution is to extend deposit insurance to the shadow system, but that creates a host of new problems. The Ricks paper is about how to extend traditional deposit insurance to the shadow system while avoiding the moral hazard and other problems that come with it. It does this by setting a risk threshold, limiting maturity transformation to firms below the threshold, extending deposit insurance to them, and then forcing all non-insured firms to use term finance rather than maturity transform to fund their activities. As I said above, I hope to cover this in more detail in a later post. It is very restrictive -- it essentially eliminates shadow banking -- and I want to think more about the consequences of the restrictions before writing more about it. The main point for now is that  even after Dodd-Frank, moral hazard problems are likely still present due to the chance of ex-post support, and the possibility of runs on the shadow system that still exists makes the moral hazard issue of paramount importance.

Wednesday, September 08, 2010

What is the Role of the State?

When I teach the History of Economic Thought, one thing we focus on is how views on the role of the state have changed over time. It has a natural cycle to it, with eras such as the highly interventionist Mercantilist years followed by Physiocratic and Classical views stressing minimal government intervention. This is followed by a rebound in the other direction, and so it goes with a Keynes followed by a Friedman in the 50s, a rebound back to Keynes in the 60s, to classical ideas following the experience of the 70s, and so on, and so on. We are involved in the same debate, and a smaller version of the grand historical lurches in each direction, yet again today:

What is the role of the state?, by Martin Wolf: It is ... a good time to ask ... the biggest question in political economy: what is the role of the state? This question has concerned western thinkers at least since Plato (5th-4th century BCE). It has also concerned thinkers in other cultural traditions... The perspective here is that of the contemporary democratic west.
The core purpose of the state is protection. This view would be shared by everybody, except anarchists... Contemporary Somalia shows the horrors that can befall a stateless society. Yet horrors can also befall a society with an over-mighty state. ...
Mancur Olson argued that the state was a “stationary bandit”. A stationary bandit is better than a “roving bandit”, because the latter has no interest in developing the economy, while the former does. But it may not be much better, because those who control the state will seek to extract the surplus over subsistence generated by those under their control.
In the contemporary west, there are three protections against undue exploitation by the stationary bandit: exit, voice ... and restraint. By “exit”, I mean the possibility of escaping from the control of a given jurisdiction, by emigration, capital flight or some form of market exchange. By “voice”, I mean a degree of control over, the state, most obviously by voting. By “restraint”, I mean independent courts, division of powers, federalism and entrenched rights.
This, then, is a brief background to ... the problem, which is defining what a democratic state ... is entitled to do. ...
There exists a strand in classical liberal or, in contemporary US parlance, libertarian thought which believes the answer is to define the role of the state so narrowly and the rights of individuals so broadly that many political choices (the income tax or universal health care, for example) would be ruled out a priori. ... I view this as a hopeless strategy...
So what ought the protective role of the state to include? Again, in such a discussion, classical liberals would argue for the “night-watchman” role. The government’s responsibilities are limited to protecting individuals from coercion, fraud and theft and to defending the country from foreign aggression.
Yet once one has accepted the legitimacy of using coercion (taxation) to provide the goods listed above, there is no reason in principle why one should not accept it for the provision of other goods that cannot be provided as well, or at all, by non-political means.
Those other measures would include addressing a range of externalities (e.g. pollution), providing information and supplying insurance against otherwise uninsurable risks, such as unemployment, spousal abandonment and so forth. The subsidization or public provision of childcare and education is a way to promote equality of opportunity. The subsidization or public provision of health insurance is a way to preserve life, unquestionably one of the purposes of the state. Safety standards are a way to protect people against the carelessness or malevolence of others or (more controversially) themselves. All these, then, are legitimate protective measures. The more complex the society and economy, the greater the range of the protections that will be sought.
What, then, are the objections to such actions? The answers might be: the proposed measures are ineffective..; the measures are unaffordable...; the measures encourage irresponsible behavior; and, at the limit, the measures restrict individual autonomy to an unacceptable degree. These are all, we should note, questions of consequences.
The vote is more evenly distributed than wealth and income. Thus, one would expect the tenor of democratic policymaking to be redistributive and so, indeed, it is. Those with wealth and income to protect will then make political power expensive to acquire and encourage potential supporters to focus on common enemies (inside and outside the country) and on cultural values. The more unequal are incomes and wealth and the more determined are the “haves” to avoid being compelled to support the “have-nots”, the more politics will take on such characteristics.
What are my personal views on how far the protective role of the state should go? In the 1970s, the view that democracy would collapse under the weight of its excessive promises seemed to me disturbingly true. I am no longer convinced of this... Moreover, the capacity for learning by democracies is greater than I had realized. The conservative movements of the 1980s were part of that learning. But they went too far in their confidence in market arrangements and their indifference to the social and political consequences of inequality. I would support state pensions, state-funded health insurance and state regulation of environmental and other externalities. I am happy to debate details.
The ancient Athenians called someone who had a purely private life “idiotes”. This is, of course, the origin of our word “idiot”. Individual liberty does indeed matter. But it is not the only thing that matters. The market is a remarkable social institution. But it is far from perfect. Democratic politics can be destructive. But it is much better than the alternatives. Each of us has an obligation, as a citizen, to make politics work as well as he (or she) can and to embrace the debate over a wide range of difficult choices that this entails.
Update: Read Martin Wolf’s response to readers’ comments

Protection, justice, correction of externalities, social insurance, and the provision of public goods (which I would like to have seen emphasized more above) are, in my view, legitimate roles of the state. I have more trouble when it comes to redistribution, I prefer that everyone have an equal chance in life with the chips falling where they may (with insurance against outcomes where individuals end up with too few chips). But redistribution to correct problems associated with, say, uncorrected market failures that redistribute income unfairly, or to compensate for an unequal playing field more generally, is another matter.

Thursday, September 02, 2010

"Companies Already Lobbying Fed on Financial Rules"

I don't like to steal other people's catch phrases (just their posts), but, well, quelle surprise!:

Companies Already Lobbying Fed on Financial Rules, by Michael Crittenden, WSJ: U.S. firms eager to shape newly-passed financial laws have wasted no time in lobbying the Federal Reserve and other agencies, according to new details released Thursday by the central bank.
Summaries of 11 meetings involving Fed staff and outside corporations and advocacy groups highlight the high-stakes rulemaking that will occur as U.S. regulators seek to implement the wide-ranging financial overhaul legislation. The meeting log shows representatives from Visa Inc. met with Fed staff just two days after President Barack Obama signed the Dodd-Frank bill into law on July 21.
The topics of conversation at that meeting: debit cards and interchange rates charged to merchants. ... The records show Bank of America Corp., J.P. Morgan Chase & Co. and American Express Co. have all met with Fed staff at least once since mid-July to discuss the interchange issue.
Firms such as Goldman Sachs Group Inc. and Citigroup Inc. have also discussed tough new rules for derivatives with Fed officials, among others. ...
It isn’t just financial firms seeking to discuss the potential changes. The Fed on Aug. 20 hosted a discussion with a group representing firms that use derivatives to hedge risks, so-called “end users”. Those present included executives from Safeway Inc. and Boeing Co., as well as representatives from the American Petroleum Institute and U.S. Chamber of Commerce. ...
Notice any interest that aren't being represented here?

The phrase "If they're too big to fail, they're too big to exist" has been heard a lot recently, but I'd add that: "If they're too big for Congress and the Fed to say no to, they're too big to exist."

It appears to me that many firms lobbying Congress and the Fed are, in fact, this big, and the question is whether we will do anything about it. I'm not optimistic that those with the ability to change things will do so as it would involve going against the interests of major campaign contributors. I would love to write a post entitled "Quell Surprise" about how wrong I am about this, I just don't think it's going to happen.

Friday, August 27, 2010

An Autopsy of Fannie Mae and Freddie Mac

The arguments below concerning Fannie and Freddie's role in the crisis have been made many times here over the last several years, see the second link at the end, but it's worth a reminder given the concerted attempt by anti-government types to make people think that Fannie and Freddie played a large role in causing the crisis. They didn't. That's not to say that Fannie and Freddie are defensible in their present form, see this discussion for example, or this from Dean Baker. But placing the blame for the crisis in the wrong places will lead to ineffective and potentially counterproductive attempts to prevent this from happening again:

An Autopsy of Fannie Mae and Freddie Mac, by Binyamin Applebaum, NY Times: Here’s a last-minute option for summer reading material: An autopsy on Fannie Mae and Freddie Mac by their overseer, the Federal Housing Finance Agency.
The report aims to inform the continuing debate in Washington about the future of the government’s role in housing finance. ... And it does a good job of making a few key points:
1. Fannie and Freddie did not cause the housing bubble. In fact, you can think of the bubble as all the money that poured into the housing market on top of their regular and continuing contributions. There’s a good chart on Page 4 of the report illustrating this...
The market share of the two government-sponsored companies plunged after 2003, and did not recover until 2008. In 2006, at the peak of the mania, the companies subsidized only one-third of the mortgage market.
2. This was not for a lack of trying. The companies bought and guaranteed bad loans with reckless abandon. Their underwriting standards jumped off the same cliff as every other participant in the mortgage market.
3. Importantly, the companies’ losses are mostly in their core business of guaranteeing loans, not in their investment portfolios. The guarantee business is the reason the companies were created. ...

More here. And here.

Sunday, August 15, 2010

Parking Spaces: What is the Free-Market Equilibrium?

In response to Robin Hanson, I think Arnold Kling makes some good points about why government intervention in parking may be necessary to resolve externality problems. Arnold doesn't say that government intervention is necessary, and he would likely resist that interpretation, a Coasian bargaining solution is the outcome in his scenario. But the usual sorts of considerations, i.e. transactions costs, unclear property rights regarding street parking in front of residences -- some people, for example, use cones and other devices to save parking spots -- and other barriers may prevent the Coasian bargaining outcome. (Robin Hanson doesn't like what I wrote either, though, again, I was trying to make a general point about equity versus efficiency and probably should have chosen another example besides parking near the ocean to make that point):

Parking Spaces: What is the Free-Market Equilibrium?, by Arnold Kling: Robin Hanson writes,

I didn't see Tyler favoring forcing prices above marginal cost, just opposing laws requiring excess supply.
So, there are two issues.

a. How much land should be devoted to parking spaces?
b. Given the answer to (a), what should be the price for parking?

I argue that for (b) the answer is often zero. A higher price would simply result in unused parking places, which does not increase welfare. Robin is falling back on issue (a), and here the thinking is that the state provides, either directly or through regulation, more parking spaces than are optimal.

Suppose there were no state provision of parking places. What would the equilibrium look like? Some possibilities:

1. You get Berlin, where the public transit is highly efficient and lots of people ride bicycles, even in the rain.

2. Individual housing developments and businesses undersupply parking. The thinking is that if parking runs out in front of your business, your customers will use the parking spaces in front of the business next door. This leads to stores putting up warning signs that say, "unless you patronize my store, your car will be towed." Neighborhoods put up signs that say, "unless you have a residential permit, your car will be towed." This imposes all sorts of enforcement costs as well as inefficient use of space. The warning signs often deter people from parking in places where they impose no cost at that particular time.

3. Land use responds, but not toward the Berlin scenario. On the contrary, businesses relocate farther away from cities, to locations where parking is cheap to supply and you don't get into fights with other businesses about towing rules. Housing developments are built without street parking but instead with large driveways--in effect, each household requires its own oversized parking lot to accommodate its peak demand . As a result of these sorts of adaptations, it takes more parking places to accommodate the same number of cars.

4. After a lot of Coasian bargaining, businesses agree to each provide a minimum number of parking places and housing developers agree to provide streets wide enough to allow parking.

The point is, you don't necessarily get (1). And you might get (4).

"Free Parking Comes at a Price"

Tyler Cowen:

Free Parking Comes at a Price, by Tyler Cowen, Commentary, NY Times: In our society, cars receive considerable attention and study... But we haven’t devoted nearly enough thought to how cars are usually deployed — namely, by sitting in parking spaces.
Is this a serious economic issue? In fact, it’s a classic tale of how subsidies, use restrictions, and price controls can steer an economy in wrong directions. Car owners may not want to hear this, but we have way too much free parking.
Higher charges for parking spaces would limit our trips by car. That would cut emissions, alleviate congestion and, as a side effect, improve land use. Donald C. Shoup, professor of urban planning at the University of California, Los Angeles, has made this idea a cause... [...continue reading...]

I don't have much to say about this in particular, just a general point about moving to market based allocations of some goods and services, particularly those controlled by government.

As the price of a good or service rises, it begins to price some people out of the market. I don't mean that they choose to consume other things instead, I mean that no matter how much they want it, they can never have it. It's not a matter of desire, or willingness to pay, they simply cannot raise the needed funds -- it's just not possible to afford the good or service in question.

Because of this there are some goods and services controlled by government, national parks come to mind, where we choose to allocate goods by other means than the price system, lotteries, waiting time, random draws, that sort of thing. It generally occurs when we think equity is a primary consideration, i.e. that everyone should have a relatively equal shot at consuming a good or service.

For example, suppose we believe that everyone should at least have a chance to swim in the ocean. Willingness to wait indicates desire for the good in the same way that willingness to pay does, and this can be used to allocate the good or service. That is, willingness to circle for a period of time looking for a parking place so you can go to the beach -- which varies with demand for parking in that area -- indicates the depth of desire to do this activity and thus has desirable allocative properties -- and we can eliminate the externalities Tyler is worried about through a tax on carbon and congestion at the pump. The supply of parking, which is controlled by government, could be determined by the carrying capacity of the beach, which is itself influenced by considerations such as habitat protection that private markets may not handle well in any case. And, of course, public transportation could be provided as an alternative, but that's not available to everyone so some parking would likely be needed. Perhaps parking wouldn't be all that expensive, or maybe it would given the prices Tyler cites in the article for places like California, but the example is intended mainly to illustrate that prices aren't the only allocation mechanism available, and that sometimes other alternatives are desirable. There are certainly cases where price is a barrier and we choose to allocate goods by other means.

As we begin to price public areas with market based mechanisms -- places owned by all of us -- we need to think hard about equity and make sure we don't exclude certain segments of the population from access to these goods, services, and places. Sometimes market based allocations are fine, but not always.

Friday, August 13, 2010

"Health Care, Uncertainty and Morality"

Kenneth Arrow believes that market failure is an inherent feature of health care markets, and that society constructs institutions, adopts norms, imposes regulations, and uses other means to try to minimize the consequences of these failures. But some of those may be breaking down, "and that has led to some of the problems we have today." Uwe Reinhardt explains:

Health Care, Uncertainty and Morality, by Uwe E. Reinhardt: In last week’s post I discussed Kenneth Arrow’s exploration of whether special characteristics set health care apart from other commodities — whether it had a “moral dimension.” ...

Professor Arrow, a Nobel laureate, explored in the early 1960s what the characteristics would be of a perfectly competitive market for an ordinary commodity, how the medical care industry deviated from those characteristics, and what aspects of health care might explain these deviations.

He concluded that virtually all the special features of the medical care industry — the role of nonprofit institutions; the expectation that physicians ... would always put the interests of their patients above their own self-interest; professional licensing and many other forms of government regulation — could “be explained as social adaptations to the existence of uncertainty in the incidence of disease and in the efficacy of treatment.”

This uncertainty has several aspects. First, physicians may not agree on the medical condition causing the symptoms the patient presents. Second, even if physicians agree in their diagnoses, they often do not agree on the efficacy of alternative responses...

Third, information on both the diagnosis of and the likely consequences of treatment are asymmetrically allocated between the sell-side (providers) and the buy-side (patients) of the health care market. The very reason that patients seek advice and treatment from physicians ... is that they expect physicians to have vastly superior knowledge... That makes the market for medical care deviate significantly from the benchmark of perfect competition, in which buyers and sellers would be equally well informed. ...

Wherever asymmetry of information is present, there exists the potential for the better-informed market participants to exploit the ignorance of the less well informed. ... Professor Arrow explained many of the nonmarket social institutions and regulations characteristic of medical care that he had identified as “attempts to overcome the lack of optimality resulting from asymmetry of information and the inability of competitive markets to allocate efficiently all of the risks inherent in health care.”

Pointedly, he said, “It is the general social consensus, clearly, that the laissez-faire solution for medicine is intolerable.”

Professor Arrow touches on the moral aspects of health care only in passing... In formal economics, the moral dimension of health care manifests itself in an externality modeled by economists as “interdependent utility functions.” That fancy jargon covers cases in which person A is happy (altruism) or unhappy (social envy) from knowing that person B consumes a certain commodity. Economists do not prescribe such interdependencies; they take them as givens in prevailing cultural norms.

With respect to health care, Professor Arrow observed that people typically have “concern for the health of others”... These tastes, Professor Arrow concluded, help explain some unique characteristics of the medical care market, for example, the redistribution of purchasing power built into private and public health insurance and the peculiar form of price discrimination practiced in the industry at the time of his writing, which struck him as not aimed mainly at profit maximization but instead as an attempt to make health care affordable to the poor. ...

In a recent interview with Conor Clarke in The Atlantic, Professor Arrow was asked how much of his 1963 paper “is still an accurate representation of the problems the health market faces.” He responded:

I think the basic analysis hasn’t changed. There are wars over the details, but the basic analysis is accepted. Some specifics have changed. If you look closely at my argument there is a sociological structure. There is a kind of sociological thesis. The market won’t work – it doesn’t work well in the health context. But something else supplements the market, and the thing I put stress on in the paper are the elements that put a non-economic influence on the market: professional commitments to provide a service, to engage in services that aren’t self-serving. Standards of caring decided by non-economic actors. And one problem we have now is an erosion of professional standards. In a way there is more emphasis on markets and self-aggrandizement in the context of health care, and that has led to some of the problems we have today.

Coming from one of the most revered economists of our age, these are sobering thoughts. ...

Tuesday, August 10, 2010

"The High Price of Motherhood"

Maxine Udall wants to know why the "price" of motherhood is so high:

Protecting Our Grandchildren: The High Price of Motherhood, by Maxine Udall: David Leonhardt at the New York Times provides a comprehensive look at the price of motherhood. It appears to be pretty high. Despite advances  over the last several decades in equalizing gender roles and pay, women still make roughly 80 cents to every male dollar. ... Much of that difference appears to be the result of women's commitment to child bearing and rearing. Despite large gains in gender equality in the US, the wage gap while somewhat narrowed, still persists and women still spend more time in child care and housework than men (and here). This translates into preferences for more time off from paid employment (what economists call "labor force participation) to bear children and a preference for jobs with shorter or more flexible work hours to accommodate the demands of child rearing. 
"But, wait!" you say. Surely the market has valued women's productivity correctly. Women are less productive because they take time out to bear and raise children. For this reason, their skills and knowledge do not keep pace with someone who is continuously gainfully employed. They show up late and leave early to pick the kids up at day care. Clearly this must lower their workplace productivity. They should receive a lower wage.
To which I reply, "Well....that's one way of looking at it and you'll do very well in your graduate studies in economics."
But let's step back and think about this. The wage rates received by individuals (and many of you will rightly dispute that they provide reliable indicators of either absolute or relative productivity) are taken to approximate the value of the incremental product they add to total output. Our national accounting methods value ... GDP by tabulating ... the value of all goods and services produced in markets [in a given time period]. GDP has long been used as an indicator of a nation's economic growth and well-being.
But what about all that non-market work women are cranking out? The stuff for which they don't get paid? Child care, child birth (production of the future units of economic production for those of you who like to think of children as durable goods) about mother's milk that builds bodies and immune systems 40 different ways? None of that shows up in GDP.  The purchased inputs to it will (for example, the food women eat and  the milk they drink to produce milk), but to take inputs as the sole measure of women's non-market productive activities forces us to assume that women add no value to those inputs, either by virtue of their managerial acumen (which will influence the mix and amounts in which they combine them, i.e., their efficiency) or by virtue of differences in production "technology."
Just pretend for a moment that you are an economist and imagine women as owner-managers of little child production and child rearing factories. Remember, the "output" here is healthy, educated kids who grow up to contribute to society, from which we all benefit. The extent to which they are healthy and educated depends greatly on decisions made by parents, but especially by mothers who spend more time with them and have primary responsibility for their prenatal health and development. Mom's matter. In single parent homes, which tend to be headed by mothers, they may matter even more. Much of what they do to produce healthy, educated kids is not captured in GDP because it isn't traded in a market.
Research by Kathleen Garrett and Nancy Cloud suggests that the contribution of women's nonmarket productive output to total societal output (and therefore to a global measure of societal well-being) is considerable, ranging from 21% to over 50% of GDP across 132 countries. None of it is captured by traditional estimates of GDP.
So far, I've been describing "sins of omission," the omission of a large portion of non-market productive endeavor by a single group from our national accounts. There are further distortions induced by the omission. For example, when women move into the labor force and purchase child care in the market in order to enable the move, both their market output and the purchased child care will be captured by traditional estimates of GDP. It looks like GDP has grown, because now child care is being delivered (and paid for) in a market. But has output really grown? After all, the same work effort and output (and perhaps more) was being produced by the woman without compensation  before she entered the labor market. All that has happened is that it has shifted to someone else and is now captured in our national accounting. Has total output really grown by the amount produced by a paid child care worker? ...
And there is another possible distortion from the omission of women's unpaid work from our national accounts. The untallied and unmeasured often becomes the unvalued. When non-market work is undervalued or unvalued, the "stuff" that is counted and valued appears that much more valuable. The result will be to shift national output away from non-market activities and their product and toward market-based activities. This was a point  made in the Report by the Commission on the Measurement of Economic Performance and Social Progress, authored by Joe Stiglitz, Amartya Sen, and Jean-Paul Fittousi. The result could be an actual decline in national well-being even as traditional indicators such as GDP are rising.
Leonhardt concludes with the hardly reassuring information that as long as women don't have children, they appear to do just as well as men wage and career-wise (assuming they manage to break through the pesky glass ceiling that still leaves women under-represented in board rooms and executive suites).
The irony here, at least from my perspective, is that we're surrounded by men (and some women) obsessing about the welfare of our grandchildren, especially the possibility that we will saddle them with an unbearable tax burden that can only (apparently) be relieved by increasing income inequality and decreasing taxes on the rich. Yet the people most likely to have a profound and lasting positive effect on the parents of those grandchildren and, by virtue of it, a profound and lasting positive effect on the endangered grandchildren, are forced to accept a 20% reduction in market wages, to struggle to find affordable, high quality child care, to be penalized for requiring flexibility in work hours, to (until 2014) face lack of health insurance if they work part-time.
So next time you hear someone arguing for cutting the safety net to protect our grandchildren from an undue tax burden, ask them what they've done lately for the grandmothers of those grandchildren. Ask them why, if we are so worried about our grandchildren, do we undervalue and penalize their mothers and grandmothers in labor markets? Why is the "price" of motherhood in foregone wages so high?

Monday, August 09, 2010

"Economic Growth and the Bush Tax Cuts"

Did the Bush tax cuts generate economic growth?:

Economic Growth and the Bush Tax Cuts, by David Leonhardt, Economix: In a detailed look at the Bush tax cuts in the current issue of Bloomberg Businessweek, Peter Coy writes:

They were supposed to promote long-term growth by realigning incentives. On that score their legacy is hard to measure because there’s no way to know how the economy would have fared without them. Many companies instituted dividends to take advantage of the tax break, but whether that induced more investment is unclear. What’s indisputable is that deficits grew while the U.S. economy rumbled along in slow gear: Growth averaged 2.3 percent a year from the end of the 2001 recession through December 2007, at which point the economy tumbled into the worst downturn since the Great Depression.

I agree there is no way to know for sure how the economy would have fared without the tax cuts. But the evidence we have does not suggest the cuts were especially good for growth. The expansion that began in 2001 and ended in 2007 had average annual economic growth of 2.7 percent. That was the slowest of any expansion since World War II.

Some of this is a reflection of slowing growth in the working-age population. If you control for these demographic changes, the 2001-7 expansion compares favorably with the 1970s, but that’s not exactly high praise. No matter how you examine the numbers, the Bush expansion was significantly weaker than the expansions of the 1990s and 1980s. It’s hard to see how the cuts induced a lot of additional investment or persuaded a lot of people to enter the work force.

Of course, the stronger expansions of the 1980s and 1990s were also not followed by terribly deep recessions. Looking at the full business cycle makes the past decade appear even worse. Might it have been even worse without tax cuts? Sure. But the burden of proof certainly seems to rest with anybody who tries to make that case.

Much of the growth that was observed during the Bush years was due to the housing bubble. That growth was illusory, and if we were to adjust for the illusory component of the growth that shows up in the measurements cited above, the Bush years would look even worse.

Saturday, August 07, 2010

"Is Health Care Special?"

Uwe Reinhardt:

Is Health Care Special?, by Uwe E. Reinhardt, Economix: On a recent episode of the television talk show “Raw Nerve,” the host William Shatner, of “Star Trek” fame, had this exchange with Rush Limbaugh:

Shatner: “Here’s my premise, and you agree with it or not. If you have money, you are going to get health care. If you don’t have money, it’s more difficult.”

Limbaugh: “If you have money you’re going to get a house on the beach. If you don’t have money, you’re going to live in a bungalow somewhere.” ... “What’s the difference?”

Shatner: “The difference is we’re talking about health care, not a house or a bungalow.”

Limbaugh: “No. No. You’re assuming that there is some morally superior aspect to health care than there is to a house. …”

One must wonder whether physicians, nurses and other workers toiling day and night in health care — let alone the medics and helicopter pilots who risk their lives to help the wounded — see their work and its product quite as Mr. Limbaugh casts it. One further wonders whether families with a cancer-stricken member are likely to view going without health care as the moral equivalent of going without a beach house.

But leaving aside speculation on the moral dimensions of health care..., it should be noted that economists, too, have long wrestled with the question of whether  health care stands apart from other goods and services traded in the market place. ...

The question of in what way health care is special, if at all, was first investigated thoroughly by the Nobel laureate economist Kenneth Arrow in his still widely celebrated 1963 article, “Uncertainty and the Welfare Economics of Medical Care.” ...

To lay down a standard to which to compare the health care sector, Professor Arrow explained first on what basis economists consider a perfectly competitive market for some good or service as “maximizing human welfare,” an outcome economists describe as “efficient.” ... If those and some other conditions are met, Professor Arrow explained, then for any given initial distribution of income and wealth that market will settle down at a unique equilibrium... This equilibrium has important attributes.

First, in what Professor Arrow calls the First Optimality Theorem of welfare economics, it can be shown that in this equilibrium ... it would be impossible through any reallocation to make someone happier without making someone else less happy. It is an allocation that economists call Pareto efficient... For any given initial distribution of income and wealth, economists declare the associated Pareto-efficient allocation ... to be “welfare-maximizing”...

Second, and very importantly, in what Arrow calls the Second Optimality Theorem, he explains that if on ethical grounds society wished to distribute a good or service (for example, education or health care or food or beach houses) among people in a particular way — like egalitarian principles — it need not have government directly involved in producing or distributing that good or service. The desired distribution could be attained by redistributing income and wealth among the citizenry in a way that would drive the perfectly competitive private market to achieve the desired allocation of the good or service among the people. Better still, it would do so in the welfare-maximizing way predicted by the First Optimality Theorem.

It is easy to see why Professor Arrow’s paper fired the imagination of generations of economists ... in their argument that public health policy should confine itself strictly to making the market of health care perfectly competitive and then to redistribute income — perhaps by means of tax-financed vouchers to help subsidize the purchase by poorer people of needed health care — in order to achieve whatever distributive ethic society wishes to impose on health care. That free-market approach would automatically take care of whatever moral aspect society wishes to impute to health care.

Having established this normative benchmark, Professor Arrow explored in the rest of his paper how close the market for health care actually comes to the characteristics of a perfectly competitive norm. In my next post, I will discuss Professor Arrow’s conclusion.

Can you guess what that conclusion will be? These markets are far from the competitive ideal, and conditions such as customers having full knowledge about the relative quality of products in the market will be hard to satisfy in any case.

Tuesday, July 27, 2010

"Government as Deux Ex Machina"?

Dave Henderson has responded to my post earlier today (responding to a post of his), and I probably did overreact to the title of his initial post -- the title I chose for my post was clearly motivated by his title choice. The title was based upon what seemed to me to be a mischaracterization of my views, and that was a large part of what prompted my response (so in his description below, if annoyed=hurt feelings, he has it right). Also, the feeling that he was trying to paint me into an ideological corner led me to return the favor, but I was overly stark in my characterization.

So I appreciate this:

Continue reading ""Government as Deux Ex Machina"?" »

David Henderson Proves He Can't Read

A response to Dave Henderson:

Continue reading "David Henderson Proves He Can't Read" »

Monday, July 19, 2010

What Should be Done with Fannie Mae and Freddie Mac?

The Economist asks:

What should be done with Fannie Mae and Freddie Mac?

Here's my response (additional responses from Laurence Kotlikoff, Phillip Swagel, Tom Gallagher, and John Makin, with others to follow, all responses):

There are two potential justifications for the existence of institutions like Fannie and Freddie. One is to solve a significant market failure in the private sector mortgage market. If there is some reason why the mortgage market does not function properly on its own, perhaps due to lack of information on one side of transactions, inefficient risk management, adverse selection, the presence of moral hazard, etc., then government can step in and fix the problem.

The second justification is the role these institutions can play in stabilizing the macroeconomy. Contrary to what you may have heard from people who want you to believe that government is always the problem and never the solution -- the people who try to blame Fannie and Freddie for the crisis despite evidence they weren't the primary cause -- having such institutions in place may allow a better response to a financial crisis than would otherwise be possible.

With respect to the market failure justification, no market is perfect, and the mortgage market is certainly no exception. Even so, I think it's hard to justify the existence of Fannie and Freddie based upon their ability to solve private sector market failures. To the extent that market failures do exist, there are better ways to overcome them. For example, there may be externalities from home ownership that accrue to the local community, but these benefits are not captured in the price of homes. If this is the case and the external benefits are large, then there may be a role for government to subsidize home ownership. However, simple mechanisms such as tax rebates can be used to solve this problem, we wouldn't need Fannie and Freddie. Since the same is true for most other examples of mortgage market failure I can think of, it's hard to justify the existence of Fannie and Freddie based upon their ability to effectively overcome imperfections in the mortgage market.

I think a better case can be made for Fannie and Freddie based upon the role that they can (and did) play in helping to stabilize a financial system that is in crisis. Fannie and Freddie concentrate risk that is dispersed across many different banks and other financial institutions. If a systemic shock hits, instead of having all the difficult problems that come with the nearly simultaneous failure of such a large number of banks, only one or two institutions get into trouble. This allows regulators to focus their efforts on these institutions as they attempt to stabilize the financial system.

The politics of the recent bailout of Fannie and Freddie are lousy, and the distribution of benefits to large banks through the backdoor bailouts Fannie and Freddie provide could certainly be improved, but mortgage markets may have failed entirely were it not for Fannie and Freddie. In addition, they have helped to keep long-term interest rates low through their purchase and guarantee of mortgage contracts. Things are bad, but a completely dysfunctional mortgage market coupled with much higher long-term interest rates would have been much, much worse.

However, it's important to note that it's not certain that the effect of institutions like Fannie and Freddie will, on net, be positive. The benefit of these institutions is that they allow us to more effectively stabilize mortgage markets -- which are prone to bubbles -- when they get into trouble. However, there is also a cost. The implicit government guarantee that stands behind Fannie and Freddie increases risk taking behavior overall making crises both more likely and more severe.

This means that effective regulation of risk taking behavior will improve the chances that Fannie and Freddie are beneficial on net. As explained at the link given above, regulation of Fannie and Freddie was relatively successful in this regard, but far from perfect. It was the private sector, not Fannie and Freddie, that took the lead in exploiting the short-run profit potential of risky mortgage products. Initially, regulation kept Fannie and Freddie out of these highly risky markets. It wasn't until Fannie and Freddie began losing market share that they began to find ways around the restrictions that prevented them from pursuing the same risky strategies. They were followers, not leaders, into subprime markets.

However, the fact that they could follow at all indicates that regulation was less than perfect. The loss of market share should have been a signal that the private sector markets needed closer scrutiny, and Fannie and Freddie should not have been allowed to follow the private sector down the sinkhole. The fact that Fannie and Freddie were allowed to follow private sector into risky markets when they began losing market share to private sector firms, and the failure to adequately regulate the risk that private sector institutions could take undermines faith in regulators and makes the case for Fannie and Freddie murky.

I still think that, overall, having Fannie and Freddie was beneficial, and I'll give lukewarm support for these institutions. But that support is conditional upon the expectation that regulators will do a better job of monitoring and regulating the amount of risk that is present in financial markets. The presence of institutions like Fannie and Freddie encourages banks to take on additional risk, and the additional risk generates costs that can more than offset the benefits Fannie and Freddie provide in terms of helping to stabilize the financial system when it gets into trouble. We need to do a better job than we have in the recent past of regulating the amount of risk that banks can take in response to the insurance that they get from the implicit government support of Fannie and Freddie. If we can't, then the case for the existence of Fannie and Freddie is much harder to make.

Friday, July 16, 2010

"In Finance We Distrust"

One more before I hit the road to my high school class reunion (35 years):

In Finance We Distrust, by Michael Spence, Commentary, Project Syndicate: Around the world,, the debate about financial regulation is coming to a head. ...
It now seems universally accepted (often implicitly) that government should establish the structure and rules for the financial system, with participants then pursuing their self-interest within that framework. If the framework is right, the system will perform well. The rules bear the burden of ensuring the collective social interest in the system’s stability, efficiency, and fairness.
But in a complex system in which expertise, insight, and real-time information are not concentrated in one place, and certainly not in government and regulatory circles, reliance on such a framework seems deficient and unwise. Moreover, it ignores the importance of trust. A better starting point, I believe, is the notion of shared responsibility for the stability of the system and its social benefits – shared, that is, by participants and regulators.
It is striking that no senior executive of whom I am aware has laid out in any detail how his or her institution’s expertise could be deployed in pursuit of the collective goal of stability. The suspicion that underlies much of today’s public anger is that these institutions, having influenced the formulation of the legal and ethical rules, could do more to contribute to stability than just obey them.
The finance industry, regulators, and political leaders need to create a shared sense of collective responsibility for the system as a whole and its impact on the rest of the economy. This set of values should be deeply embedded in the industry – and thus should transcend haggling over regulation. It should take precedence over narrow self-interest or the potential profit opportunities associated with exploiting an informational advantage. And it should be thought of as an addition to the guiding norms, rules, and ethics associated with “normal” times.
Some will object that this idea won’t work because it runs counter to greedy human nature. Yet such values shape other professions. In medicine, there is a huge and unbridgeable gap in expertise and information between doctors and patients. The potential for abuse is enormous. It is limited by professional values that are inculcated throughout doctors’ training, and which are bolstered by a quiet form of peer review.
By itself, such a shift in values and the implicit model that defines roles certainly will not solve the challenge of systemic risk. Neither will fiddling with the rules. Taken seriously, however, it could help provide an ongoing reminder of the importance of the financial sector to the broader well-being of the economy. It might even help start rebuilding trust.

In medicine, I think it's regulation, not professional ethics that prevents the most blatant types of snake oil treatments and other means of exploiting consumers. If there is lots and lots of money to be made selling the latest cure for baldness, acne, wrinkles, whatever, some doctor will step in and sell the treatment whether it works or not. And ethical standards do not seem to stop conflicts of interest such as doctors owning testing centers, and then having a tendency to order more tests than necessary at those facilities. To the extent that this has been prevented, it's been due to government intervention, not shared ethics.

In general, it's the threat of loss of license and lawsuits, not condemnation from peers, that is the real constraint on behavior for those lacking the conscience that might stop them from engaging in such practices. If there were no regulations to prevent it, then any snake oil treatment that proved highly profitable would be quickly adopted and mimicked by others with a medical license but lacking the ethics that are supposed to come with it. In the end, it's the government's ability to take away a medical license that prevents doctors from, say, charging $250 for an office visit that is all but guaranteed to result in a medical marijuana card (and even with such a threat, such doctors exist, at least in Oregon). Without that fear, ethics alone would not be enough. The ethical standards must be backed by a hammer, and for doctors that is their license to practice. I don't mean to condemn all doctors as lacking such ethics, or even most, not at all. This isn't needed in most cases. But it only takes a few who are willing to ignore ethical standards to undermine the system.

That is the problem with this approach. If there is a way to make a profit and no penalty for pursuing it other than peers shaking a finger at you and saying what a rotten person you are, then somebody will step in and take the opportunity to get wealthy. If there are millions to be made, the shaking fingers are tolerable and others will surely follow suit. If there is no hammer that comes down and imposes a penalty when people engage in such behavior, then there will always be those who are wiling to take the money over their reputations.

With that said, however, I still think there is something to be gained by having such ethical standards in place. Norms for appropriate behavior are important, and they can constrain some behavior. But we shouldn't rely too much upon them, or hope that they can somehow substitute for regulation with teeth. Because ethics without strong penalties for violating them won't do much to constrain highly profitable schemes that separate people from their money, and government is best suited to enforce these types of rules and regulations, i.e. to provide the teeth. We can hope the private sector will do this on its own through professional societies and the like, and that when these societies condemn a person or practice it will have an effect. But these organizations often turn into ways for the industry to protect itself against new entrants -- it becomes a way for industry insiders to protect themselves rather than a way of protecting the public -- and the penalties they impose don't mean much if there is no law or regulation to prevent the behavior they condemn. So I hope we don't make the mistake of thinking that we can rely upon the private sector to suddenly find ethics that weren't there before and fix these kinds of problems on its own. Again, ethics are useful and they should go as far as they can, but I think a strong set of rules and regulators who are ready and willing to enforce them are the real key to fixing these kinds of problems.

"The Uses and Abuses of Economic Ideology"

Adair Turner has lost faith in the idea that making market more complete necessarily leads to a more stable financial system:

The Uses and Abuses of Economic Ideology, by Adair Turner, Cpmmentary, Project Syndicate: ...[I]n the arena of financial economics, a vulgar version of equilibrium theory rose to dominance in the years before the financial crisis, portraying market completion as the cure to all problems, and mathematical sophistication decoupled from philosophical understanding as the key to effective risk management. Institutions such as the IMF ... set out a confident story of a self-equilibrating system. ... And at regulatory agencies like Britain’s Financial Services Authority (which I lead), the belief that financial innovation and increased market liquidity were valuable because they complete markets and improve price discovery was not just accepted; it was part of the institutional DNA.
This belief system did not, of course, exclude the possibility of market intervention. But it did determine assumptions about the appropriate nature and limits of intervention. For example,... requirements for information disclosure could help overcome asymmetries of information between businesses and consumers. Similarly, regulation and enforcement to prevent market abuse was justifiable... And regulation to increase market transparency was ... acceptable ... since transparency, like financial innovation, was believed to complete markets and help generate increased liquidity and price discovery.
But the belief system of regulators and policymakers ... tended to exclude the possibility that rational profit-seeking by professional market participants might generate rent-seeking behavior and financial instability rather than social benefit – even though several economists had clearly shown why that could happen. Policymakers’ conventional wisdom reflected, therefore, a belief that only interventions aimed at identifying and correcting the very specific imperfections blocking attainment of the nirvana of market equilibrium were legitimate. ...[I]t was beyond the ideology to recognize that information imperfections might be so deep as to be unfixable, and that some forms of trading activity, however transparent, might be socially useless. ...
Market efficiency and market completion theories can help reassure major financial institutions’ top executives that they must in some subtle way be doing God’s work... But we should not underplay the importance of ideology. Sophisticated human institutions ... are impossible to manage without a set of ideas that are sufficiently complex and internally consistent to be intellectually credible, but simple enough to provide a workable basis for day-to-day decision-making.
Such guiding philosophies are most compelling when they provide clear answers. And a philosophy that asserts that financial innovation, market completion, and increased market liquidity are always and axiomatically beneficial provides a clear basis for regulatory decentralization.
Here, I suspect, is where the greatest challenge for the future lies. For, while the simplified pre-crisis conventional wisdom appeared to provide a complete set of answers resting on a unified intellectual system and methodology, really good economic thinking must provide multiple partial insights, based on varied analytical approaches. Let us hope that ...[we] learn that lesson.

Wednesday, July 14, 2010

"A Roosevelt Moment for America’s Megabanks?"

Simon Johnson is happier than I expected he'd be with the Dodd-Frank financial reform bill:

A Roosevelt Moment for America’s Megabanks?, by Simon Johnson, Commentary, Project Syndicate: Just over a hundred years ago, the United States led the world in terms of rethinking how big business worked – and when the power of such firms should be constrained. In retrospect, the breakthrough legislation ... was the Sherman Antitrust Act of 1890. The Dodd-Frank Financial Reform Bill, which is about to pass the US Senate, does something similar – and long overdue – for banking.
Prior to 1890, big business was widely regarded as more efficient and generally more modern than small business. Most people saw the consolidation of smaller firms into fewer, large firms as a stabilizing development that rewarded success and allowed for further productive investment. The creation of America as a major economic power, after all, was made possible by giant steel mills, integrated railway systems, and the mobilization of enormous energy reserves through such ventures as Standard Oil.
But ever-bigger business also had a profound social impact, and here the ledger entries were not all in the positive column. The people who ran big business were often unscrupulous, and in some cases used their dominant market position to drive out their competitors – enabling the surviving firms subsequently to restrict supply and raise prices. ... Big business brought major productivity improvements, but it also increased the power of private companies to act in ways that were injurious to the broader marketplace – and to society.
The Sherman Act itself did not change this situation overnight, but, once President Theodore Roosevelt decided to take up the cause, it became a powerful tool that could be used to break up industrial and transportation monopolies. By doing so, Roosevelt and those who followed in his footsteps shifted the consensus. ...
Why are these antitrust tools not used against today’s megabanks...? The answer is that the kind of power that big banks wield today is very different from what was imagined by the Sherman Act... The banks do not have monopoly pricing power in the traditional sense, and their market share – at the national level – is lower than what would trigger an antitrust investigation in the non-financial sectors. ...
Now, however, a new form of antitrust arrives – in the form of the Kanjorski Amendment, whose language was embedded in the Dodd-Frank bill. Once the bill becomes law, federal regulators will have the right and the responsibility to limit the scope of big banks and, as necessary, break them up when they pose a “grave risk” to financial stability. ...
Representative Paul Kanjorski ... recently [said], “The key lesson of the last decade is that financial regulators must use their powers, rather than coddle industry interests.” ... Regulators can do a great deal, but they need political direction from the highest level in order to make genuine progress. Teddy Roosevelt, of course, preferred to “Speak softly and carry a big stick.” The Kanjorski Amendment is a very big stick. Who will pick it up?

One argument against breaking up large banks, one I've given myself, is that it won't necessarily eliminate systemic risk. A shock that pushes a large bank into bankruptcy could just as easily cause a large number of smaller firms engaged in the same business to fail. This could create just as much trouble for the financial system as the failure of a single bank encompassing the smaller entities. In fact, it could be even harder for regulators to figure out how to address the failure of, say, one hundred small firms rather than just one large firm. Thus, breaking up large banks may do little to reduce systemic risk, but, as the argument goes, there is a chance that efficiency will fall. If so, then this is not a good policy.

But I think there are several counterarguments to this. First, there maybe some shocks that would take a single, large bank down, but might not do the same to the smaller banks derived from it. The key here is that the smaller banks pursue diversified strategies so that only some of them are vulnerable to a particular type of shock. If they all do the same thing as the large bank did before it was broken up, then they will still face common risks. However, even so, I'd still worry that there is not that much safety from braking banks up, i.e. that most shocks that would take down large banks will also take down enough small banks to create similar problems. So it's not clear to me that the benefit from breaking banks up to reduce systemic risk is very large.

But what about the costs? The second point is that the question of the efficient scale for banks has never been satisfactorily addressed so far as I can tell. How much efficiency would be lost if we cut the largest bank into two independent pieces? If the answer is zero, or very little, then we should break these banks up. After all, their large size gives them considerable political clout, enough that they have the ability to influence legislation and regulation on their behalf. That gives large banks an economic advantage that they shouldn't have. If there is no cost to breaking them up, and if it helps to reduce their economic and political power, power that gives then an advantage over their smaller rivals, then we should do so.

Third, I am not convinced that traditional antitrust law could not have been applied in many instances. I fully agree that existing anti-trust law was not comprehensive enough, and that new legislation was needed. But I also believe that some markets were highly concentrated economically so that traditional law would have applied, and that this concentration was the source of the systemic risk (AIG and insurance markets come to mind here).

This is why I think the point about leadership is essential. We have been through several decades where the prevailing attitude among those with the power to affect pubic opinion and, more importantly, to affect the enforcement of anti-trust law was that markets could take care of themselves. The build up of market power was not something to worry about, market forces would solve the problem, or so it was believed. This belief allowed economic power and the political power that comes with it to become far too concentrated, and market forces did not counteract this tendency. The power is now entrenched and difficult to dislodge. We need leadership to change this, and if the financial sector is the opening salvo in that effort, I'm all for it. But I suspect the actual implementation of both new and old laws designed to curtail economic and political power will, in the end, come up far short of what many of us are hoping for.

Wednesday, July 07, 2010

Pure Competition and the Soup Pot of the Enemy

I have a new post at CBS MoneyWatch: Is it true that the pursuit of individual self-interest always leads to a socially optimum outcome? Not if you're a crab (but it does work for snails):

Pure Competition and the Soup Pot of the Enemy

There's actually a good lesson here about when competition maximizes societal gains, and when it doesn't.

Friday, July 02, 2010

Rogoff: Can Good Emerge From the BP Oil Spill?

Kenneth Rogoff says anger among twenty somethings might "be the ticket to rekindling interest in a carbon tax":

Can Good Emerge From the BP Oil Spill?, by Kenneth Rogoff, Commentary, Project Syndicate: Perhaps it is a pipe dream, but it is just possible that the ongoing BP oil-spill catastrophe in the Gulf of Mexico will finally catalyze support for an American environmental policy with teeth. ...
The fact is, the BP oil spill is on the cusp of becoming a political game-changer of historic proportions. If summer hurricanes push huge quantities of oil onto Florida’s beaches and up the Eastern seaboard, the resulting political explosion will make the reaction to the financial crisis seem muted.
Anger is especially rife among young people. Already stressed by extraordinarily high rates of unemployment, twenty-somethings are now awakening to the fact that their country’s growth model – the one they are dreaming to be a part of – is, in fact, completely unsustainable, whatever their political leaders tell them. ...
Might a reawakening of voter anger be the ticket to rekindling interest in a carbon tax? ... Why might a carbon tax be viable now, when it never has been before? The point is that, when people can visualize a problem, they are far less able to discount or ignore it. Gradual global warming is hard enough to notice, much less get worked up about. But, as high-definition images of oil spewing from the bottom of the ocean are matched up with those of blackened coastline and devastated wildlife, a very different story could emerge.
Some say that young people in the rich countries are just too well off to mobilize politically, at least en masse. But they might be radicalized by the prospect of inheriting a badly damaged ecosystem. Indeed, there is volatility just beneath the surface. Modern-day record unemployment and extreme inequality may seem far less tolerable as young people realize that some of the most cherished “free” things in life – palatable weather, clean air, and nice beaches, for example – cannot be taken for granted.
Of course, I may be far too optimistic in thinking that the tragedy in the Gulf will spur a more sensible energy policy... A great deal of the US political reaction has centered on demonizing BP and its leaders, rather than thinking of better ways to balance regulation and innovation.
Politicians understandably want to deflect attention from their own misguided policies. But it would be far better if they made an effort to fix them. A prolonged moratorium on offshore and other out-of-bounds energy exploration makes sense, but the real tragedy of the BP oil spill will be if the changes stop there. How many wake-up calls do we need?

The response to the financial crisis from Congress has been disappointing, and it's hard not to let that color thoughts about climate change legislation. I'm not optimistic. But if there is action, I doubt it will be through a carbon tax. People may be angry, but the anger is at specific targets, e.g. BP. There are attempts to say "you, the American public caused this by your insatiable demand for energy," but I think that will backfire. especially if it can be linked to PR from BP. People don't think it's individually their fault that the oil spill happened, and while they are more than willing to make other people pay for it -- those who are responsible -- I'm not so sure they are ready to place the burden on themselves. The same goes for climate change policies more generally. I just don't see a carbon tax in the cards.

Update: Richard Green:

Ken Rogoff thinks the BP spill might produce a groundswell for a carbon tax...: ...but Mark Thoma is not so sure [Rogoff's take is here].

I am actually more inclined to agree with Rogoff on this one. When environmental problems are easily visible, they seem to generate political consensus for action. The air quality in Los Angeles, which was obviously awful 30 years ago, if much better currently--the vast majority of days are quite clear now(although we still have the problem of invisible small particulates). The 1952 smog disaster led to major policy changes in the UK. The BP disaster could similarly mobilize policy.

Mark could still be right about this--I just hope he is not.

Saturday, June 26, 2010

Sheila Bair on ‘Too Big to Fail’

Saturday, June 19, 2010

Tail Risks, Time Lags, and Herding Behavior

Rajiv Sethi explains how herding behavior toward high risk outcomes can occur, and how this can happen without assuming the kinds of departures from rationality observed in behavioral economics:

[For] tail risks...: there can be a significant time lag between the acceptance of the risk and the realization of a catastrophic event. In the interim, those who embrace the risk will generate unusually high profits and place their less sanguine competitors in the difficult position of either following their lead or accepting a progressively diminishing market share. The result is herd behavior with entire industries acting as if they share the expectations of the most optimistic among them. It is competitive pressure rather than human psychology that causes firms to act in this way, and their actions are often taken against their own better judgment. 
This ecological perspective lies at the heart of Hyman Minsky's analysis of financial instability, and it can be applied more generally to tail risks of all kinds. ... As an account of the (environmental and financial) catastrophes with which we continue to grapple, I find it more compelling and complete than the psychological story. And it has the virtue of not depending for its validity on systematic, persistent, and largely unexplained cognitive biases among professionals in high stakes situations.

More here.

Update: Brad DeLong:

Rajiv Sethi Misses a Point..., by Brad DeLong: Mark Thoma sends us to Rajiv Sethi, who writes:

Rajiv Sethi: On Tail Risk and the Winner's Curse: [T]hose with the most optimistic expectations will take the greatest risks and suffer the most severe losses when the low probability events that they have disregarded eventually come to pass. But tail risks are unlike auctions in one important respect: there can be a significant time lag between the acceptance of the risk and the realization of a catastrophic event. In the interim, those who embrace the risk will generate unusually high profits...

What Rajiv misses is that it may not be "in the meantime." To the extent that the optimism of noise traders leads them to hold larger average positions in assets that possess systemic risk, their average returns will be higher in a risk-averse world--not just in those states of the world in which the catastrophe has not happened yet, but quite possibly averaged over all states of the world including catastrophic states.

In general, noise traders' returns average returns are:

  • higher because of their optimism about risky assets
  • lower because their fluctuating opinions tend to make them buy high and sell low
  • higher because their irrational changes of opinion make the risky assets they concentrate on even more risky--and so drive rational risk-averse investors away, push the prices of such assets down, and returns on such assets up.

There is another factor:

  • it is possible for noise traders to have a higher average return and yet a lower median market share--repeated independent investments of agents with crra-like utiity functions tend to generate log-normal distributions, and because noise traders' distributions have higher variance they may have a greater expected wealth but a ower median wealth because of a long upper tail.

But Rajiv doesn't want to put his noise-trader optimists into a model with flint-eyedsteel-nerved ice-bloodedrisk averse rational calculators. He wants the other agents in his models to be:

[L]ess sanguine competitors in the difficult position of either following [the optimists'] lead or accepting a progressively diminishing market share. The result is herd behavior with entire industries acting as if they share the expectations of the most optimistic among them. It is competitive pressure rather than human psychology that causes firms to act in this way, and their actions are often taken against their own better judgment...

I wouldn't say "rather than": I would say "along with." For, as my teacher Charles Kindleberger liked to say:

Kindleberger: Overestimation of profits comes from euphoria, affects firms engaged in the production and distributive processes, and requires no explanation. Excessive gearing arises from cash requirements that are low relative both to the prevailing price of a good or asset and to possible changes in its price. It means buying on margin, or by installments, under circumstances in which one can sell the asset and transfer with it the obligation to make future payments. As firms or households see others making profits from speculative purchases and resales, they tend to follow: "Monkey see, monkey do." In my talks about financial crisis over the last decades, I have polished one line that always gets a nervous laugh:

There is nothing so disturbing to one’s well-being and judgment as to see a friend get rich...

Update: Rajiv's response (in comments):

...I understand the logic of your first point (which you made in your 1990 JPE paper with SSW) but I'm not sure it applies in the case of the risks taken by BP and AIG, which is what my post was concerned with. You could make the case that even with bankruptcy, the cumulative dividend payouts resulted in higher average returns, or that a portfolio of such firms would have beaten the market on a risk-adjusted basis, but the claim seems empirically dubious to me. The Kindeberger quote is wonderful, but the claim is about interdependent preferences, not cognitive limitations. I don't doubt that cognitive limitations matter (I started my post with the winner's curse after all) but I was trying to shift the focus to interactions and away from psychology. In general I think that the Minsky story can be told with very modest departures from rationality, which to me is one of the strengths of the approach.

Tuesday, June 15, 2010

"The Economics of Libertarianism"

Ed Glaeser:

The Economics of Libertarianism, Revealed, by Edward Glaeser, Economix: It is both the best and worst of times for libertarians. On the plus side, real, live politicians who might conceivably get elected call themselves libertarians. On the negative side, true libertarians have lost their ancient luxury of being able to avoid any responsibility for the gaffes and errors of political leaders.
Libertarianism rests on two bedrock beliefs: human freedom is a great good and the public sector tends to screw things up. The first belief is based more on faith than empirical result; the second derives from millennia of human experience. The increased appeal of libertarianism today reflects a nonpartisan view that the public sector has been deeply problematic under either party. It is a backlash against President Bush as well as President Obama. ... Libertarians tend to think that the Bush years taught that all governments were flawed, not that everything would be better with a new leader who would expand the public sector. ...
I always find it refreshing to take a quick, clean intellectual shower in the cold, pure waters of libertarian thought, but I find myself most interested in the murky areas on the edge of libertarianism... Libertarians are rarely anarchists. Almost all of them believe in some form of state power, at the very least the protection of private property and the enforcement of contracts. Many of them, including Milton Friedman, are quite comfortable with larger exercises of state power, including the redistribution of resources to those who have less. ...
But once the need for public action is accepted, things start getting very muddy and we can’t rely on either a love of liberty or fear of the state for guidance. Consider the purely hypothetical case of a massive oil spill in the Gulf of Mexico. The traditional libertarian would argue that regulation is unnecessary because the tort system will hold the driller liable for any damage. But what if the leak is so vast that the driller doesn’t have the resources to pay? The libertarian would respond that the driller should have been forced to post a bond or pay for sufficient insurance to cover any conceivable spill. Perhaps, but then the government needs to regulate the insurance contract and the resources of the insurer.
Even more problematically, the libertarian’s solution requires us to place great trust in part of the public sector: the court system. At times, judges have been bribed; any courtroom can be influenced by the best lawyers that money can buy. Andrei Shleifer and I have argued that the early regulations were appealing precisely because of a sense that the courts couldn’t be counted upon to protect private property. ...

He says "Libertarians tend to think that the Bush years taught that all governments were flawed." I thought the lesson was a bit different. When someone stacks the deck to in favor of a particular outcome, we shouldn't be fooled into drawing general conclusions when that outcome is realized. Bush made his ideological belief about government self-fulfilling -- he stacked the deck in their favor (e.g. hiring incompetent people to head agencies like FEMA, filling regulatory agencies with people opposed to regulation, etc., etc.). Drawing general conclusions from an outcome that was forced by design, as libertarians have apparently done with Bush, does confirm preexisting biases, but it doesn't tell you much beyond that.

The lesson of the Bush administration is not that "all governments were flawed." We learned about an extreme, i.e. how bad things can be when a president sabotages government agencies by appointing cronies -- people who provided important political support -- to head important agencies rather than qualified, competent administrators. And the system was not quite as robust to this manipulation as I thought it would be. I had assumed the permanent staffs within these agencies would still go about their business as before, that the changes would be mostly superficial. But the ideological purge reached deeper into these agencies than I expected (and the Obama administration has been far to slow in taking action to reverse this).

The Bush administration was deeply flawed, no doubt about that, and it was partly (though not entirely) by design. But there is no general lesson here about all governments, only the particulars of an administration that did it's very best to validate libertarian beliefs about government.

Monday, June 14, 2010

"A High-Five for the Invisible Hand"

Bill Easterly reviews "The Rational Optimist":

A High-Five for the Invisible Hand, by William Easterly, Book Review, NY Times: The word “market” tends to set off a religious war. Opponents accuse proponents of blind faith in the Miracle of the Market. The proponents too often seem to confirm this accusation by overpromising and underproving what the market can do. (Opponents are often guilty of equally unthinking belief in the Immaculate Government Intervention.) Each side recites its creeds, giving heart to the faithful but making no converts.
Alas, Matt Ridley’s new book, “The Rational Optimist,” which argues for markets as the dominant source of human progress, is such a case. It didn’t have to be so. Ridley, the author of “The Red Queen” and “Genome,” is a gifted science writer who could have brought a more neutral perspective to the debate. ... It’s an example of a phenomenon many economists have noted: natural scientists have remarkably low standards for reasoned argument when they discuss social science, as compared with the rigor they bring to their home fields.
Ridley does synthesize a great deal of material, spinning the history of humanity from the stone ax to the computer mouse. He recites colorful stories of successive waves of traders...
Ridley’s key concept is gains from exchange, which make possible gains from specialization, which in turn make possible technological innovation. Gains from exchange and specialization certainly rank up there with the most important economic ideas of all time. ... But Ridley repeats these ideas so often that the reader gets weary. He makes them into a comprehensive explanation for all of human progress, which is more weight than they can bear. ...
Ridley’s free market history is one-­sided in another way: He stresses “market” a lot more than “free.” We hear little of the political ideals of equality and individual liberty, usually considered prerequisites for both exchange and innovation. These ideals are doubly potent because people desired them for their own sake as well as for their utility in achieving prosperity. ...
Nor does Ridley grapple with why so many people doubt market-based progress. His entertaining account of how such pessimism is always in fashion ... is tone-deaf to the 20th-century traumas that were huge setbacks for the gospel of progress. “Despite the wars,” he writes, “in the half-century to 1950, the longevity, wealth and health of Europeans improved faster than ever before” — a true statement that surely misses the point.
Ridley also fails to really address inequality and uncertainty. The free market may produce cornucopia, doubters concede. But it also gave Richard Fuld of Lehman Brothers $60,000 a day (in 2007, the year before the company went bankrupt) while one billion other people survived on a dollar a day. In his discussion of global warming, Ridley argues that we’ve avoided all previous doomsday predictions. But our resourcefulness, or our luck, could run out sooner or later.
A case for individual freedom and market exchange would have to convince doubters that alternatives would create even more inequality and uncertainty, or something worse. Such a case could argue that some of those 20th-century traumas were caused by a backlash against both the “free” and the “market,” and that central planning tends to create even more rigid inequality between political “ins” and “outs” while lacking the creativity needed to cope with future threats. But the case must move from “maybe” to logic and evidence. Alas, this book does not get there.
So read “The Rational Optimist” for its fascinating history of trade and innovation. But also ponder whether the debate over markets can move forward while it remains a purely religious war. Those willing to confront honestly all the doubts about the “free market” might then actually be persuasive in arguing that it is the worst system humans have ever tried — except for all the others.

This arguments mostly about comparative systems -- capitalism versus everything else -- and there are certainly those who wish to debate this question and who would argue for some alternative system. But for most people that question is settled. And for me, that's not what the debate over the "Miracle of the Market" is all about. There's a difference between saying the present system can be improved through government intervention, and saying the system should be replaced by some other economic and social system.

I think that government intervention at the microeconomic level, e.g. breaking up firms with excessive market power, and government intervention at the macroeconomic level, e.g. through monetary and fiscal policy, can improve the operation of the market system we live under. That's not a rejection of the market system, it's an attempt to make it better by preventing the build up of harmful political and economic power, and by correcting the tendency of market economies to have harmful boom and bust cycles.

Sunday, June 13, 2010

What Should the Price of Gasoline Be?

Barkley Rosser:

What Should the Price of Gasoline Be?: In today's WaPo Business section, in "Think gas is too pricey? Think again," Ezra Klein reports on a recent study by Ian Perry of Resources for the Future that attempts to estimate the cost of all the externalities arising from the use of gasoline in vehicular transportation. At the time of the report, the average price of gas in the US was $2.72 per gallon, but after adding in (in order of estimated costs), 52 cents for traffic congestion, 41 cents for auto accidents, 30 cents for energy security, 20 cents for climate change, 12 cents for local pollution, and 10 cents for oil dependence, this brings a supposedly more efficient prices of $4.37 per gallon. It is unclear if that 12 cents for local pollution was estimated before or after the BP oil spill in the Gulf of Mexico happened.

Saturday, June 12, 2010

"The Simple Economics of Broadband Regulation"

Shane Greenstein discusses "The Simple Economics of Broadband Regulation." The discussion (from mid May) comes in response to a court ruling in the Comcast v. FCC case. Here's how the FCC describes the regulatory problems caused by the ruling in the Comcast case:

A month ago, the United States Court of Appeals for the D.C. Circuit issued an opinion...  [in] Comcast v. FCC, the so-called Comcast/BitTorrent case.  The case began in 2007, when Internet users discovered that Comcast was secretly degrading its customers’ lawful use of BitTorrent and other peer-to-peer applications.  In 2008, the FCC issued an order finding Comcast in violation of federal Internet policy as stated in various provisions of the Communications Act and prior Commission decisions.
The D.C. Circuit held that the Commission’s 2008 order lacked a sufficient statutory basis ... because the Commission, in 2002, classified cable modem offerings entirely as “information services” (a category not subject to any specific statutory rules...), it could not, in 2008, enforce ... nondiscrimination and consumer protection principles in the cable modem context. ...
[U]nder Comcast, the FCC’s 2002 classification decision greatly hampers its ability to accomplish a task the Commission unanimously endorsed in 2005:  “ensur[ing] that broadband networks are widely deployed, open, affordable, and accessible to all consumers.” 

The court ruled that the FCC did not have the authority to stop Comcast from limiting the services of applications that flow over its network (i.e. the ruling allowed net non-neutrality). In response, the FCC reclassified the cable carriers so as to reestablish their regulatory authority. What are the economics behind the FCC's response (the original post has quite a bit more detail)?:

The Simple Economics of broadband regulation, bu Shane Greenstein: There is a simple economic rationale behind the FCC’s recent announcement, made last week by Chairman Julius Genachowski, on May 6th.The FCC had to act. The costs of not acting were too great. Here is why. Broadband carriers have strong economic incentives to provide services that compete with the applications of others. Yet, those same broadband carriers carry the data of all those applications. These carriers face what is often called “mixed incentives”, and until recently all carriers were forbidden from acting on them. Genchowski wanted to keep things that way, but an appellate court made that hard to do.
Let me make the issue concrete. Just ask your neighbor what they would think of the following: Would they be angry if Comcast blocked Skype from operating and told all users they had to go through an approved vendor of IP telephony? Would your neighbor be unhappy if Google slowed down when the search concerned local car dealers because AT&T broadband had a local search service on which local car dealers advertised? Would your neighbor be frustrated if they could not go to Hulu, but instead had to go to the approved TV distributor who worked with Verizon?
Look, none of that has happened yet, but that is because it was forbidden by regulators until a few weeks ago. It is not anymore, and that illustrates what any sensible regulator should fear. ... Households have gotten used to having unrestricted choice online of innovative services, and there would be a minor revolt if narrow firm self-interest got in the way of that.
I have no axe to grind with carriers, so let me say that more positively. The ... present limitations have fostered an innovative ecosystem. Software vendors and Internet hosting companies have developed a range of innovative services in anticipation of (1) better infrastructure on which to run it, and (2) sending their applications across broadband lines that behave the same way everywhere.
In other words, application vendors do not worry about which carrier delivers the data to which homes because carriers are not allowed to act on their mixed incentives. Knowing that, application developers innovate in all sorts of ways that users enjoy.
Those simple economics explains quite a bit of regulatory action..., it is not surprising the FCC feared what would happen if it permitted no legal restraint on carrier action. ...
There were two economic reasons to take action, and both point towards limiting mixed incentives. One has to do with the incentives to act on mixed incentives today, and the other has to do with the long term trends of the evolutions of the network, which reinforces incentives to act on mixed incentives tomorrow...
I am not saying anything that many other analysts have not noticed. Comcast’s management is ambitious. So is AT&T’s, and so is Verizon’s. They must be considering how a carrier can develop its own television service (instead of relying on Hulu), or get a piece of revenue from selling online movies (instead of letting Netflix collect all the revenue), or get a piece of online advertising for local services (instead of letting Google collect all the revenue).
This is an old lesson in regulatory economics. Commercial ambition from a dominant firm is a good thing when it fuels competitive conduct, innovative services, and invading of new service territories. Ambition from dominant firms is usually not such a good thing when it motivates such those firms to block a rival’s access to channels, when it leads dominant firms to refuse to deal with potential rivals, and when it leads dominant firms to raise a rival’s cost. ...
Mixed incentives are a very old problem in communications access regulation, and easily understood by every regulator on the planet. Every regulator can sense the danger of letting carriers move down the slippery slope of not cooperating with another participant in the Internet ecosystem. That bright line had to be protected, if only for the sake of preserving the innovative ecosystem that has driven the Internet forward in these last two decades.
Let’s hope the ecosystem continues to be innovative in the next decade with these new set of rules.

Friday, June 11, 2010

Too Big to Exist?

pgl at EconoSpeak:
...While the “drill baby drill” proponents of offshore drilling used to tell us that we had the technology to keep oil spills from happening or once they did happen from becoming environmental nightmares - as we have recently learned, technology has not advanced that much. If oil companies are shielded from paying more than pennies on the dollar for such potential problems, it is no wonder they under-invest in this technology. The stock market seems to be signaling that BP shareholders may indeed pay much more than pennies on the dollar. If that does happen, bravo! ...
John Boehner voices a very different view than mine:
In response to a question from TPMDC, House Minority Leader John Boehner said he believes taxpayers should help pick up the tab for the clean up. "I think the people responsible in the oil spill--BP and the federal government--should take full responsibility for what's happening there," Boehner said at his weekly press conference this morning. Boehner's statement followed comments last Friday by US Chamber of Commerce CEO Tom Donohue who said he opposes efforts to stick BP, a member of the Chamber, with the bill. "It is generally not the practice of this country to change the laws after the game," he said. "Everybody is going to contribute to this clean up. We are all going to have to do it. We are going to have to get the money from the government and from the companies and we will figure out a way to do that." So today I asked Boehner, "Do you agree with Tom Donohue of the Chamber that the government and taxpayers should pitch in to clean up the oil spill?" The shorter answer is yes.
This sounds like the Congressman wants us to subsidize negative externalities.

Essentially, the well was too big too fail, but it failed anyway. Technology has given us the ability to create things whose individual or collective failure can cause tremendous damage, from oil wells to complicated financial assets, more so than ever before.

It is evident that we need to do a much better job of evaluating and regulating these types of risks. If the answer to the question "what if there's a problem and all of our safeguards fail" is "there will be a huge disaster," and if we really can't quantify the true risks due to black swans, etc., or be absolutely certain we can handle or even think of every possible contingency, then perhaps these technologies are too big to safely exist.

Monday, June 07, 2010

Surowiecki: The Regulation Crisis

James Surowiecki argues, correctly I think, that one of the key factors in effective regulation is the societal attitude about the value of what regulators do:

The Regulation Crisis, by James Surowiecki: A few weeks after B.P.’s Deepwater Horizon oil rig blew up and crude started spewing into the Gulf, Ken Salazar, the Secretary of the Interior, ordered the breakup of the Minerals Management Service—the agency ... supposedly in charge of offshore drilling. It was a well-deserved death: during the past decade, M.M.S. officials had let oil companies shortchange the government on oil-lease payments, accepted gifts from industry representatives, and, in some cases, literally slept with the people they were regulating. When the industry protested against proposed new regulations (including rules that might have prevented the B.P. blowout), M.M.S. backed down. ...
M.M.S.’s bad behavior was unusually egregious, but it’s hard to think of a recent disaster ... that wasn’t abetted by inept regulation. Mining regulators... Financial regulators... The S.E.C... These failures weren’t accidents. They were the all too predictable result of the deregulationary fervor that has gripped Washington in recent years, pushing the message that most regulation is unnecessary... The result is that agencies have often been led by people skeptical of their own duties. ...
The obvious problems of graft and the revolving door between government and industry, in other words, were really symptoms of a more fundamental pathology: regulation itself became delegitimatized... This view was exacerbated by the way regulation works... Too many regulators, for instance, are political appointees, instead of civil servants. This erodes the kind of institutional identity that helps create esprit de corps, and often leads to politics trumping policy. Congress, meanwhile, often takes a famine-or-feast attitude toward funding, allocating less money when times are good and reinflating regulatory budgets after the inevitable disaster occurs. ... This ... also contributes to the sense that regulation is something it’s O.K. to skimp on. ...
[T]he history of regulation both here and abroad suggests that how we think about regulators, and how they think of themselves, has a profound impact on the work they do. ... So reforming the system isn’t about writing a host of new rules; it’s about elevating the status of regulation and regulators. More money wouldn’t hurt: as ... George Stigler and Gary Becker point out, paying regulators competitive salaries ... would attract talent and reduce the temptations of corruption. It would also send a message about the value of what regulators do. That’s important... If we want our regulators to do better, we have to embrace a simple idea: regulation isn’t an obstacle to thriving free markets; it’s a vital part of them.

Friday, June 04, 2010

Stiglitz: Financial Re-Regulation and Democracy

Joe Stiglitz on financial reform legislation and the danger that the outcome will "be a sad day for democracy":

Financial Re-Regulation and Democracy, by Joseph E. Stiglitz, Commentary, Project Syndicate: It has taken ... more than three years since the beginning of the global recession brought on by the financial sector’s misdeeds for the United States and Europe finally to reform financial regulation. Perhaps we should celebrate the regulatory victories in both Europe and the United States. ... But the battle – and even the victory – has left a bitter taste. ...
Banks that wreaked havoc on the global economy have resisted doing what needs to be done. Worse still, they have received support from the Fed, which ... reflects the interests of the banks that it was supposed to regulate.
This is important not just as a matter of history and accountability: much is being left up to regulators. And that leaves open the question: can we trust them? To me, the answer is an unambiguous no, which is why we need to “hard-wire” more of the regulatory framework. The usual approach – delegating responsibility to regulators to work out the details – will not suffice.
And that raises another question: whom can we trust? On complex economic matters, trust had been vested in bankers ... and in regulators... But the events of recent years have shown that bankers can make megabucks, even as they undermine the economy and impose massive losses on their own firms. Bankers have also shown themselves to be “ethically challenged.” ...
We should toast the likely successes: some form of financial-product safety commission will be established; more derivative trading will move to exchanges and clearing houses...; and some of the worst mortgage practices will be restricted. Moreover, it looks likely that the outrageous fees charged for every debit transaction – a kind of tax that goes not for any public purpose but to fill the banks’ coffers – will be curtailed.
But the likely failures are equally noteworthy: the problem of too-big-to-fail banks is now worse than it was before the crisis. Increased resolution authority will help, but only a little: in the last crisis, US government “blinked,” failed to use the powers that it had, and needlessly bailed out shareholders and bondholders – all because it feared that doing otherwise would lead to economic trauma. As long as there are banks that are too big to fail, government will most likely “blink” again. ...
The Senate bill’s provision on derivatives is a good litmus test: the Obama administration and the Fed, in opposing these restrictions, have clearly lined up on the side of big banks. If effective restrictions on the derivatives business of government-insured banks ... survive in the final version of the bill, the general interest might indeed prevail over special interests, and democratic forces over moneyed lobbyists.
But if, as most pundits predict, these restrictions are deleted, it will be a sad day for democracy – and a sadder day for prospects for meaningful financial reform.

Thursday, June 03, 2010

"Bankers Have Been Sold Short"

Raghuram Rajan:

Bankers have been sold short by market distortions, by Raghuram Rajan, Commentary, Financial Times: ...Inquiries under way are bound to unearth more instances of ethically, and even legally, challenged bankers. ... How do we instill more social values in the industry? Or is banker greed mostly good? ...
Take for instance a trader who sells short the stock of a company he feels is being mismanaged. He does not see the workers who lose their jobs or the hardship that unemployment causes their families. But short sellers perform a valuable social function by depriving poorly managed companies of resources they will waste. A company whose stock price tanks will not be able to raise financing easily and could be forced to close down.
The trader does not cause the company to go out of business. ... Mismanagement is the source of the company’s troubles; the trader merely holds up a mirror to reflect it. The best measure of the trader’s value to society is whether he made money from the trade... This is why free-market capitalism works and why bankers usually do good even as they do very well for themselves.
However, when the discipline of markets breaks down, as it sometimes does, the finely incentivized financial system can derail quickly and cause immense damage. The very anonymity of money then makes it a poor mechanism for guiding financiers’ activities toward socially desirable ends. Did the mortgage broker make his fees by offering a variety of sensible options to the professional couple who were looking to upgrade their house, or did he do so by urging an elderly couple to refinance into a mortgage they could not afford? When the broker’s loans are scrutinized by sensible banks that refuse to refinance shaky mortgages, there is a market check on his behavior that forces him to focus on persuading the professional couple instead of deluding the elderly one. When the market is willing to buy any loan he makes, however, he leans towards easy pickings.
The key then to understanding the recent crisis is to see why markets offered inordinate rewards for poor and risky decisions. Irrational exuberance played a part, but perhaps more important were the political forces distorting the markets. The tsunami of money directed by a US Congress ... towards expanding low income housing, joined with the flood of foreign capital inflows to remove any discipline on home loans. And the willingness of the Fed to stay on hold until jobs came back, and indeed to infuse plentiful liquidity if ever the system got into trouble, eliminated any perceived cost to having an illiquid balance sheet. Chastise the banker who hankers after his bonus, but also pity him for he is looking for his primary measure of self-worth to be restored. Rather than attempting to instill social purpose in him, however, it is probably more useful for society to target the forces that distorted the market.

I agree that it we should correct bad incentives when we are aware they exist, but as I've argued before, we are never going to be able to ensure that financial markets are perfectly safe. Another meltdown is always possible. So we should also put measures such as strict leverage ratios in place that limit the damage when the next crisis occurs.

Also, in addition to the causes of the crisis that he mentions, I'd add poor risk assessment due to the use of mathematical models that did not properly account for systemic risks, and the reliance on ratings agencies that used the same bad models and had incentives to rubber stamp approvals indicating assets of high quality. I'd also mention deregulation of the financial sector, and an ideology that promoted the idea that greed (maximizing self-interest) is good independent of the conditions that exist in a particular market, i.e. independent of whether the market discipline mentioned above is present.

A change in thinking that recognizes that markets do not necessarily self-correct or lead to optimal societal outcomes on their own, that oversight and regulation is needed to ensure that markets function properly (and safely when a meltdown could threaten the larger economy), is an important part of the solution to the problem. If regulators had taken seriously the possibility that financial markets could meltdown the way that they did and insisted upon the proper safeguards, we might not even be talking about a crisis or what new regulations are needed, the crisis might have been prevented. I think new regulation is needed, as well as a new attitude from those who are charges with enforcing the regulations on the books. But the attitude of regulators can change with the administration in power, and regulators make mistakes in any case, so some part of the new regulation must make discretionary errors by regulators less costly (hence the call for measures such as strict leverage ratios in the previous post).

Let me also add this from Paul Krugman (as noted below, this point has been made repeatedly -- for quite a bit more on the role, or lack thereof, of the CRA, Fannie, and Freddie in the crisis, see here and here.):

Things Everyone In Chicago Knows, by Paul Krugman: Which happen not to be true.

It was deeply depressing to see Raguram Rajan write this:

The tsunami of money directed by a US Congress, worried about growing income inequality, towards expanding low income housing, joined with the flood of foreign capital inflows to remove any discipline on home loans.

That’s a claim that has been refuted over and over again. But what happens, I believe, is that in Chicago they don’t listen at all to what the unbelievers say and write; and so the fact that those libruls in Congress caused the bubble is just part of what everyone knows, even though it’s not true.

Just to repeat the basic facts here:

1. The Community Reinvestment Act of 1977 was irrelevant to the subprime boom, which was overwhelmingly driven by loan originators not subject to the Act.

2. The housing bubble reached its point of maximum inflation in the middle years of the naughties:

Robert Shiller

3. During those same years, Fannie and Freddie were sidelined by Congressional pressure, and saw a sharp drop in their share of securitization:


while securitization by private players surged:


Of course, I imagine that this post, like everything else, will fail to penetrate the cone of silence. It’s convenient to believe that somehow, this is all Barney Frank’s fault; and so that belief will continue.

Tuesday, June 01, 2010

Rogoff: The BP Oil Spill’s Lessons for Regulation

Kenneth Rogoff frets over our ability to regulate complex emerging technologies:

The BP Oil Spill’s Lessons for Regulation, by Kenneth Rogoff, Commentary, Project Syndicate: As the damaged BP oil well continues to spew millions of gallons of crude..., the immediate challenge is how to mitigate an ever-magnifying environmental catastrophe. ... The disaster, however, poses a much deeper challenge to how modern societies deal with regulating complex technologies. The accelerating speed of innovation seems to be outstripping government regulators’ capacity to deal with risks, much less anticipate them.
The parallels between the oil spill and the recent financial crisis are all too painful: the promise of innovation, unfathomable complexity, and lack of transparency (...we know only a very small fraction of what goes on at the oceans’ depths.) Wealthy and politically powerful lobbies put enormous pressure on even the most robust governance structures. It is a huge embarrassment for US President Barack Obama that he proposed – admittedly under pressure from the Republican opposition – to expand offshore oil drilling greatly just before the BP catastrophe struck.
The oil technology story, like the one for exotic financial instruments, was very compelling and seductive. Oil executives bragged that they could drill a couple of kilometers down, then a kilometer across, and hit their target within a few meters. Suddenly, instead of a world of “peak oil” with ever-depleting resources, technology offered the promise of extending supplies for another generation. ... Some developing countries, most notably Brazil, have discovered huge potential offshore riches.
Now all bets are off. ... Will Brazil really risk its spectacular coastline for oil, now that everyone has been reminded of what can happen? What about Nigeria, where other risks are amplified by civil strife? ...
The basic problem of complexity, technology, and regulation extends to many other areas of modern life. Nanotechnology and innovation in developing artificial organisms offer a huge potential boon to mankind, promising development of new materials, medicines, and treatment techniques. Yet, with all of these exciting technologies, it is extremely difficult to strike a balance between managing “tail risk” – a very small risk of a very large disaster – and supporting innovation.
Financial crises are almost comforting by comparison. Speculative bubbles and banking crises have been a regular feature of the economic landscape for centuries. Awful as they are, societies survive them. ... If ever there were a wake-up call for Western society to rethink its dependence on ever-accelerating technological innovation for ever-expanding fuel consumption, surely the BP oil spill should be it. ...
Economics teaches us that when there is huge uncertainty about catastrophic risks, it is dangerous to rely too much on the price mechanism to get incentives right. Unfortunately, economists know much less about how to adapt regulation over time to complex systems with constantly evolving risks, much less how to design regulatory resilient institutions. Until these problems are better understood, we may be doomed to a world of regulation that perpetually overshoots or undershoots its goals.
The finance industry already is warning that new regulation may overshoot – that is, have the unintended effect of sharply impeding growth. Now, we may soon face the same concerns over energy policy, and not just for oil. ...
The balance of technology, complexity, and regulation is without doubt one of the greatest challenges that the world must face in twenty-first century. We can ill afford to keep getting it wrong.

Just one comment. If the risks of too little regulation are very large -- catastrophic oil spills, financial crises, and the like -- much larger than the potential costs from too much regulation stifling innovative activity -- then there should be a bias toward erring on the side of too much rather than too little regulation. Thus, the fact that "new regulation may overshoot" is not worrisome, it is optimal, and it seems to be we could have used what would have appeared to be overshooting prior to the recent financial and oil spill crises.

In addition, suppose that regulation had prevented the recent meltdowns and accidents. We never would have known -- catastrophic events that don't occur are not observable -- and there would have been considerable pressure to ease the regulations that were in place. There would have been argument after argument about regulatory overshooting, and considerable pressure from the "loan, baby, loan" and "drill, baby, drill" crowds to ease off (see Obama opening up offshore areas to drilling). I can even imagine Rogoff writing a Project Syndicate piece making the argument that financial markets are unduly constrained. So I am not particularly persuaded by worries that we will overshoot. As I said, we could have used a little more of what would have been called overshooting prior to the recent crises.

Friday, May 28, 2010

"Digital Robber Barons?"

Paul Krugman is on vacation, so I essentially picked an article randomly (by date) from the PKarchive. This column appeared December 6, 2002. Not much has changed:

Digital Robber Barons?, by Paul Krugman, Commentary, NY Times: Bad metaphors make bad policy. Everyone talks about the "information highway." But in economic terms the telecommunications network resembles not a highway but the railroad industry of the robber-baron era — that is, before it faced effective competition from trucking. And railroads eventually faced tough regulation, for good reason: they had a lot of market power, and often abused it.
Yet the people making choices today about the future of the Internet — above all Michael Powell, chairman of the Federal Communications Commission — seem unaware of this history. They are full of enthusiasm for the wonders of deregulation, dismissive of concerns about market power. And meanwhile tomorrow's robber barons are fortifying their castles.
Until recently, the Internet seemed the very embodiment of the free-market ideal — a place where thousands of service providers competed, where anyone could visit any site. And the tech sector was a fertile breeding ground for libertarian ideology, with many techies asserting that they needed neither help nor regulation from Washington.
But the wide-open, competitive world of the dial-up Internet depended on the very government regulation so many Internet enthusiasts decried. Local phone service is a natural monopoly, and in an unregulated world local phone monopolies would probably insist that you use their dial-up service. The reason you have a choice is that they are required to act as common carriers, allowing independent service providers to use their lines.
A few years ago everyone expected the same story to unfold in broadband. The Telecommunications Act of 1996 was supposed to create a highly competitive broadband industry. But it was a botched job; the promised competition never materialized.
For example, I personally have no choice at all: if I want broadband, the Internet service provided by my local cable company is it. I'm like a 19th-century farmer who had to ship his grain on the Union Pacific, or not at all. If I lived closer to a telephone exchange, or had a clear view of the Southern sky, I might have some alternatives. But there are only a few places in the U.S. where there is effective broadband competition.
And that's probably the way it will stay. The political will to fix the 1996 act, to create in broadband the kind of freewheeling environment that many Internet users still take for granted, has evaporated.
Last March the F.C.C. used linguistic trickery — defining cable Internet access as an "information service" rather than as telecommunications — to exempt cable companies from the requirement to act as common carriers. The commission will probably make a similar ruling on DSL service, which runs over lines owned by your local phone company. The result will be a system in which most families and businesses will have no more choice about how to reach cyberspace than a typical 19th-century farmer had about which railroad would carry his grain.
There were and are alternatives. We could have restored competition by breaking up the broadband industry, restricting local phone and cable companies to the business of selling space on their lines to independent Internet service providers. Or we could have accepted limited competition, and regulated Internet providers the way we used to regulate AT&T. But right now we seem to be heading for a system without either effective competition or regulation.
Worse yet, the F.C.C. has been steadily lifting restrictions on cross-ownership of media and communications companies. The day when a single conglomerate could own your local newspaper, several of your local TV channels, your cable company and your phone company — and offer your only route to the Internet — may not be far off.
The result of all this will probably be exorbitant access charges, but that's the least of it. Broadband providers that face neither effective competition nor regulation may well make it difficult for their customers to get access to sites outside their proprietary domain — ending the Internet as we know it. And there's a political dimension too. What happens when a few media conglomerates control not only what you can watch, but what you can download?
There's still time to rethink; a fair number of Congressmen, from both parties, have misgivings about Mr. Powell's current direction. But time is running out.

One way to induce competition is to follow the model used for phone services and force internet service providers to sell their services at wholesale rates to other providers (e.g., see unbundled network elements). In any case, there's no reason why there should be so little competition in this industry other than political power that these firms have.

Tuesday, May 25, 2010

"The Effects of Airline Deregulation: What’s The Counterfactual?"

Tom Bozzo argues that the case for airline deregulation isn't as clear as many people would have you believe:

The Effects of Airline Deregulation: What’s The Counterfactual?, by Tom Bozzo: Matt Welch at the Reason blog takes credit for airline deregulation on behalf of libertarianism:

The “worldview” of libertarianism suggested, back in the early 1970s, that if you got the government out of the business of setting all airline ticket prices and composing all in-flight menus, then just maybe Americans who were not rich could soon enjoy air travel. At the time, people with much more imagination and pull than Gabriel Winant has now dismissed the idea as unrealistic, out-of-touch fantasia. They were wrong then, they continue to be wrong now about a thousand similar things, and history does not judge them harsh enough.

Mark Kleiman observes that transportation deregulation was more directly the progeny of 1970s Brookings-esque neoliberalism (though I’d grant Welch that libertarians got there first), though Kleiman doesn’t take issue with the basic claim that deregulating prices and service offerings “was, on balance, a good thing.” This argument ultimately rests on the declines in airfares and resulting democratization of air travel that Welch cites; indeed that’s what the Brookings-esque neoliberals I know cite when they’re defending the deregulatory record.

The catch is that all such economic comparisons must be counterfactual: they must show an improvement not with respect to CAB-set fares of the late-1970s, but rather with respect to what reasonably competent regulation could have produced under the other circumstances of the deregulated era. (This, FWIW, is one of Robert W. Fogel’s central insights into what makes economic history economic history.) If the comparison exercise is tough by the (inappropriate) historical yardstick thanks to declines in (average) service quality and the airline industry’s trail of fleeced stakeholders, then the counterfactual comparison is going to be tougher still thanks to a couple of factors that should have produced large declines in airline costs and hence fares even in the absence of deregulation.

The factors of note are a pair of technological advancements — the development of high bypass ratio turbofans suitable for shorter-haul airliners and the demise of the flight engineer’s job thanks to cockpit automation, both of which have origins predating deregulation — and the long secular decline in oil prices through the deregulated era’s zenith prior the crash of the 1990s stock market bubble. Since a regulator could have promoted adoption of the cost-saving technologies and passed the resulting productivity improvements and input cost decreases through to fare-payers using elementary regulatory technologies, deregulation must have produced substantial fare reductions relative to the late CAB era to have a claim to constituting a true improvement.

One of the airline industry’s problems is that it isn’t “revenue adequate” or able to recover its total costs including a normal return to investors. If you thought airlines were incurring costs efficiently, then moving towards revenue adequacy would require more revenues and hence higher average fares. On the face of things, that wouldn’t look good for a regulated alternative providing more secure revenues to the industry. However, there are dynamic efficiency counterbalances to the apparent static inefficiency under regulation: revenue adequacy implies having money for efficiency-improving investments. For instance, U.S. legacy airlines have somewhat notoriously kept relatively aged fleets in the air. Partly, that was a deliberate strategy that blew up when the Goldilocks conditions of the late-90s ended, and partly they don’t have the money to turn over their fleets as fast as they arguably should.

The formerly regulated transportation industries shared, to one extent or another, cost structures under which an efficient carrier would go broke under econ 101 perfect competition with prices driven down to marginal costs. So the question isn’t so much whether carriers will exercise such market power as they have in order to survive, but how. Real firms might or might not do that better than a real regulator. I do think there’s a good case to be made for some degree of pricing and service liberalization with regulatory policing of “excessive” use of market power; that’s a one-sentence version of the Staggers Act’s approach to the (very successful) freight rail industry.

Monday, May 24, 2010

Reich: Obama’s Regulatory Brain

I don't fully agree with Robert Reich's view expressed below and elsewhere that breaking up the big banks is the key to solving the too big too fail problem. It does mean that the failure of an individual firm would be less worrisome, and hence less likely to get help from the government, but that assumes shocks are idiosyncratic rather than common. However, the shocks we should worry about are common -- systemic to use another term. The shocks that are capable of bringing down large institutions would, if the large banks had been broken up into smaller pieces, bring down all the smaller banks just as easily. Collectively they would still be too big too fail and still require a bailout. And it's certainly true that there are historical episodes where the failure of a large number of small banks was the problem.

But there is another reason to worry about big banks, the economic and political power that comes with size. Even if it's true that breaking banks into smaller pieces doesn't help much, if at all, to make the system safer, all else equal, it does make it much less likely that banks will capture regulators and legislators. And it makes it harder for banks to use their economic power in the marketplace to increase profits at the expense of consumers, or to maintain a financial marketplace where high risk, high reward, taxpayers pay the bill it things go sour strategies are allowed.

So yes, break up the big banks if for no other reason than to curtail economic and political power. And if I'm wrong and this also makes the system substantially safer, so much the better. But what I was really interested in here is the distinction Reich makes between the regulatory and structural approaches, a distinction I think is important:

Obama’s Regulatory Brain, by Robert Reich: The most important thing to know about the 1,500 page financial reform bill passed by the Senate last week — now on he way to being reconciled with the House bill — is that it’s regulatory. If does nothing to change the structure of Wall Street. The bill omits two critical ideas for changing the structure of Wall Street’s biggest banks so they won’t cause more trouble in the future, and leaves a third idea in limbo. The White House doesn’t support any of them. 
First, although the Senate bill seeks to avoid the “too big to fail” problem by pushing failing banks into an “orderly” bankruptcy-type process, this regulatory approach isn’t enough. The Senate roundly rejected an amendment that would have broken up the biggest banks... You do not have to be an algorithm-wielding Wall Street whizz-kid to understand that the best way to prevent a bank from becoming too big to fail is preventing it from becoming too big in the first place. ... Because traders and investors know they are too big to fail, these banks have a huge competitive advantage over smaller banks.
Another crucial provision left out of the Senate bill would be to change the structure of banking by resurrecting the Depression-era Glass-Steagall Act and force banks to separate commercial banking ... from investment banking. Here, too, the bill takes a regulatory approach..., it would not erode the giant banks’ monopoly over derivatives trading, adding to their power and inevitable “too big to fail” status.
Which brings us to the third structural idea, advanced by Senator Blanche Lincoln. She would force the banks to do their derivative trades in entities separate from their commercial banking. This measure is still in the bill, but is on life-support after Paul Volcker, Tim Geithner, and Fed chair Ben Bernanke came out against it. Republicans hate it. The biggest banks detest it. ... Almost no one in Washington believes it will survive the upcoming conference committee. But it’s critical. ...
Wall Street’s lobbyists have fought tooth and nail against these three ideas because all would change the structure of America’s biggest banks. The lobbyists won on the first two, and the Street has signaled its willingness to accept the Dodd bill, without Lincoln’s measure. The interesting question is why the president, who says he wants to get “tough” on banks, has also turned his back on changing the structure of American banks — opting for a regulatory approach instead.
It’s almost exactly like health care reform. Ideas for changing the structure of the health-care industry — a single payer, Medicare for all, even a so-called “public option” — were all jettisoned by the White House in favor of a complex set of regulations that left the old system of private for-profit health insurers in place. The final health care act doesn’t even remove the exemption of private insurers from the nation’s antitrust laws. 
Regulations don’t work if the underlying structure of an industry — be it banking or health care — got us into trouble in the first place. ... A regulatory rather than structural approach to deep-seated problems in complex industries like banking and health care is also vulnerable to the inevitable erosion that occurs when industry lobbyists insert themselves into the regulatory process. Tiny loopholes get larger. Delays get longer. Legislative words are warped and distorted to mean what industry wants them to mean. ...
Inevitably, top regulators move into the industry they’re putatively trying to regulate, while top guns in the industry move temporarily into regulatory positions. This revolving door of regulation also serves over time to erode all serious attempt at overseeing an industry.
The only way to have a lasting effect on industries as large and intransigent as banking and health care is to alter their structure. That was the approach taken to finance by Franklin D. Roosevelt in the 1930s, and by Lyndon Johnson to health care (Medicare) in the 1960s. 
So why has Obama consistently chosen regulation over restructuring? Because restructuring Wall Street or health care would surely elicit firestorms from these industries. Both are politically powerful, and Obama did not want to take them on directly.
A regulatory approach allows for more bargaining, not only in the legislative process but also, over time, in the rule-making process as legislation is put into effect. It’s always possible to placate an industry with a carefully-chosen loophole or vague legislative language that will allow the industry to continue to go on much as before. 
And that’s precisely the problem. 

The line between structural and regulatory intervention is a bit vague in some cases, but it's still conceptually useful to categorize the types of intervention in this way. As I've said many times, we should try as hard as we can to make the system safe, but we'll never be able to guarantee that the financial system is immune to sudden collapse. Thus, as we think about the structural and regulatory changes that are needed, we should be sure to make changes that minimize the fallout when another collapse occurs, as it eventually will. Much of the change that is needed is structural in nature, but not all, e.g. I'd categorize leverage limits, which I view as critical to minimizing the fallout when problems occur, as regulatory.

However, as noted above structural change is harder than imposing new regulations. The fact that legislators are shying away from the harder to impose types of change out of fear of losing reelection support from the financial industry points to the political power the industry still has, and to the need for structural change to reduce this political (and economic) power. If we cannot muster the political will to make such changes in light of the most devastating financial collapse since the Great Depression, that does not bode well for the future.

Thursday, May 20, 2010

"James Tobin's Hirsch Lecture"

Rajiv Sethi discusses James Tobin's "four distinct conceptions of financial market efficiency," particularly his notion of functional efficiency"

James Tobin's Hirsch Lecture, by Rajiv Sethi: James Tobin's Fred Hirsch Memorial Lecture "On the Efficiency of the Financial System" was originally published in a 1984 issue of the Lloyds Bank Review, and republished three years later in a collection of his writings. Willem Buiter discussed the essay at some length about a year ago in a provocative post dealing with the regulation of derivatives. Both the original essay and Buiter's discussion of it remain well worth reading today as guides to the broad principles that ought to underlie financial market reform.

In his essay, Tobin considers four distinct conceptions of financial market efficiency:

Efficiency has several different meanings: first, a market is 'efficient' if it is on average impossible to gain from trading on the basis of generally available public information... Efficiency in this meaning I call information arbitrage efficiency.

A second and deeper meaning is the following: a market in a financial asset is efficient if if its valuations reflect accurately the future payments to which the asset gives title... I call this concept fundamental valuation efficiency.

Third, a system of financial markets is efficient if it enables economic agents to insure for themselves deliveries of goods and services in all future contingencies, either by surrendering some of their own resources now or by contracting to deliver them in specified future contingencies... I call efficiency in this Arrow-Debreu sense full insurance efficiency.

The fourth concept relates more concretely to the economic functions of the financial industries... These include: the pooling of risks and their allocation to those most able and willing to bear them... the facilitation of transactions by providing mechanisms and networks of payments; the mobilization of saving for investments in physical and human capital... and the allocation of saving to to their more socially productive uses. I call efficiency in these respects functional efficiency.

The first two criteria correspond, respectively, to weak and strong versions of the efficient markets hypothesis. Tobin argues that the weak form is generally satisfied on the grounds that "actively managed portfolios, allowance made for transactions costs, do not beat the market." He notes, however that efficiency in the second (strong form) sense is "by no means implied" by this, and that "market speculation multiplies several fold the underlying fundamental variability of dividends and earnings."

My own view of the matter (expressed in an earlier post) is that such a neat separation of these two concepts of efficiency is too limiting: endogenous variations in the composition of trading strategies result in alternating periods of high and low volatility. Nevertheless, as an approximate view of market efficiency over long horizons, I feel that Tobin's characterization is about right. 

Full insurance efficiency requires complete markets in state contingent claims. This is a theoretical ideal that is impossible to attain in practice for a variety of reasons: the real resource costs of contracting, the thinness of potential markets for exotic contingent claims, and the difficulty of dispute resolution. Nevertheless, Tobin argues for the introduction of new assets that insure against major contingencies such as inflation, and securities of this kind have indeed been introduced since his essay was published.

Finally, Tobin turns to functional efficiency, and this is where he expresses greatest concern:

What is clear that very little of the work done by the securities industry, as gauged by the volume of market activity, has to do with the financing of real investment in any very direct way. Likewise, those markets have very little to do, in aggregate, with the translation of the saving of households into corporate business investment. That process occurs mainly outside the market, as retention of earnings gradually and irregularly augments the value of equity shares...

I confess to an uneasy Physiocratic suspicion, perhaps unbecoming in an academic, that we are throwing more and more of our resources, including the cream of our youth, into financial activities remote from the production of goods and services, into activities that generate high private rewards disproportionate to their social productivity. I suspect that the immense power of the computer is being harnessed to this 'paper economy', not to do the same transactions more economically but to balloon the quantity and variety of financial exchanges. For this reason perhaps, high technology has so far yielded disappointing results in economy-wide productivity. I fear that, as Keynes saw even in his day, the advantages of the liquidity and negotiability of financial instruments come at the cost of facilitation nth-degree speculation which is short sighted and inefficient...
Arrow and Debreu did not have continuous sequential trading in mind; when that occurs, as Keynes noted, it attracts short-horizon speculators and middlemen, and distorts or dilutes the influence of fundamentals on prices. I suspect that Keynes was right to suggest that we should provide greater deterrents to transient holdings of financial instruments and larger rewards for long-term investors.

Recall that these passages were published in 1984; the financial sector has since been transformed beyond recognition. Buiter argues that Tobin's concerns about functional efficiency are more valid today than they have ever been, and is particularly concerned with derivatives contacts involving directional bets by both parties to the transaction:

[Since] derivatives trading is not costless, scarce skilled resources are diverted to what are not even games of pure redistribution.  Instead these resources are diverted towards games involving the redistribution of a social pie that shrinks as more players enter the game.

The inefficient redistribution of risk that can be the by-product of the creation of new derivatives markets and their inadequate regulation can also affect the real economy through an increase in the scope and severity of defaults.  Defaults, insolvency and bankruptcy are key components of a market economy based on property rights.  There involve more than a redistribution of property rights (both income and control rights).  They also destroy real resources.  The zero-sum redistribution characteristic of derivatives contracts in a frictionless world becomes a negative-sum redistribution when default and insolvency is involved.  There is a fundamental asymmetry in the market game between winners and losers: there is no such thing as super-solvency for winners.  But there is such a thing as insolvency for losers, if the losses are large enough.
The easiest solution to this churning problem would be to restrict derivatives trading to insurance, pure and simple.  The party purchasing the insurance should be able to demonstrate an insurable interest.  [Credit Default Swaps] could only be bought and sold in combination with a matching amount of the underlying security. 

The debate over naked credit default swaps is contentious and continues to rage. While market liquidity and stability have been central themes in this debate to date, it might be useful also to view the issue through the lens of functional efficiency. More generally, we ought to be asking whether Tobin was right to be concerned about the size of the financial sector in his day, and whether its dramatic growth over the couple of decades since then has been functional or dysfunctional on balance.

Thursday, May 13, 2010

Shiller: How Nutritious Are Your Investments?

Robert Shiller hopes that regulatory reform will include the requirement that financial products have "a standardized disclosure label analogous to the nutritional labels on foods":

How Nutritious Are Your Investments?, by Robert J. Shiller, Commentary, Project Syndicate: Those labels that you see on packaged foods listing their ingredients and nutritional values had their beginnings in an international scandal and in the efforts by governments to deal constructively with the public outrage that followed.
The scandal erupted with the publication in 1906 of Upton Sinclair’s novel The Jungle... The public response to the book’s description of unsanitary conditions in the industry was so strong that the United States Congress enacted the Pure Food and Drug Act – the first law to require labeling of contents on food packages – the very same year. ...
These labels are undoubtedly useful to consumers, but it is unlikely that many manufacturers, if given the choice, would have introduced them on their own.
That is how regulatory progress is often made. The history of legislative reform is ... long periods of time during which public apathy prevents any progress, interrupted by scandals that suddenly make progress possible. Entrenched interests ... resist change with all of their lobbying efforts, but public outrage is too strong for them to win.
We have to hope that the same kind of outcome will emerge from the financial scandals that have produced public outrage analogous to that directed at the food industries in Upton Sinclair’s day. As was the case then, public outrage today is at a level that might well overwhelm the lobbying efforts of entrenched interests. ...
For today we need laws that will require purveyors of financial products to provide the essential information that consumers need. ...[I]nvestment products like mutual funds should include a standardized disclosure label analogous to the nutritional labels on foods. The structure of the label should be developed by a committee of academics, regulators, and industry executives with the objective of promoting informed comparison among consumers of investment products. ...
The ... standardized disclosure should give the consumer an understandable measure of long-term risk. ... Not all investors will be able to interpret even ... simple measures of the outlook for an investment. But neither are all consumers of food able to interpret the quantities of nutrients that are shown on nutritional labels. These facts should be there to allow those people who will look at them to do so, and to encourage them to spread the information...
The standardized disclosure label should not, however, include past returns on investments. This is because most investors overreact to past returns... Moreover,... when an advertisement for an investment product does report a prior average return, it should also include a statement of the uncertainty associated with that return. ...
Including such information on financial products would give an enormous boost to the efficiency and efficacy of our financial products in serving customers’ needs. The only reason that such labeling has not yet been required is the same reason that nutritional labels were not required long ago on foods. Public outcry at a time of scandal forced progressive change then; we should hope that it does so now.

I don't think it's on the financial reform agenda, though there was talk of providing "plain vanilla" options for some financial products awhile back to help with this problem. But that got dropped due to opposition from the financial industry.

Is there a good reason not to do this? I couldn't think of one. There is a small cost to the banks to develop the labels, but if it's a standard form that shouldn't be too costly, particularly relative to the potential benefit to consumers from overcoming the informational market failure.

Tuesday, May 04, 2010

The Rebirth of Regulation?

Robert Reich says its time for regulation to make a comeback:

The Rebirth of Regulation, by Robert Reich: What do oil giant BP, the mining company Massey Energy, and Goldman Sachs have in common? They’re all big firms involved in massive plunder. BP’s oil spill is already one of the biggest and most damaging in American history. Massey’s mine disaster, claiming the lives of 29 miners, is one of the worst in recent history. Goldman’s alleged fraud is but a part of the largest financial meltdown in 75 years. ...

Where were the regulators? Why didn’t the Department of Interior’s Minerals Management Service make sure offshore oil rigs have backup systems to prevent blowouts? One clue: You may remember MMS’s wild drinking parties exposed during the Bush era.

Where was the Mine Safety and Health Administration before the Upper Big Branch mine exploded? MSHA says it fined the company for a whole string of violations, but the law didn’t allow fines high enough to deter the company. Which raises the next question: Given Massey’s record, why didn’t the Bush-era MSHA seek to change the law and increase the penalties?

Why didn’t the Securities and Exchange Commission spot fraud on the Street when it was happening? Well, as we all now know, the Bush SEC was asleep at the wheel.

But don’t blame it all on George W. For thirty years, deregulation has been all the rage in Washington. Even where regulations exist, Congress has set such low penalties that disregarding the regulations and risking fines has been treated by firms as a cost of doing business. And for years, enforcement budgets have been slashed, with the result that there are rarely enough inspectors to do the job. The assumption has been markets know best, and when they don’t civil lawsuits and government prosecutions will deter wrongdoing.

Wrong. When shareholders demand the highest returns possible and executive pay is linked to stock performance, many companies will do whatever necessary to squeeze out added profits. And that will spell disaster – giant oil spills, terrible coal-mine disasters, and Wall Street meltdowns – unless the nation has tough regulations backed up by significant penalties, including jail terms for executives found guilty of recklessness, and vigilant enforcement.

After thirty years of deregulation, it’s time for the rebirth of regulation: Not heavy-handed and unncessarily costly regulation, but regulation that’s up to the task of protecting the public from companies and executives that will do almost anything to make a buck.

It's not at all clear that "the largest financial meltdown in 75 years" will result in new financial regulation that is more than window dressing designed to appease voters without actually curtailing financial sector activity. If, in the end, the regulatory change that is implemented does little to make us safer from future financial meltdowns even after such a large economic downturn, that's not a good sign for those who are hoping that the gulf oil spill will provide the motivation for new and substantial environmental regulation. But maybe financial regulation will turn out better than I expect.

Monday, May 03, 2010

FRBSF Economic Letter: Is the “Invisible Hand” Still Relevant?

Steven LeRoy asks if "free markets", i.e. markets free of government intervention, generally perform better than markets where government intervenes:

Is the “Invisible Hand” Still Relevant?, by Stephen LeRoy, FRBSF Economic Letter: The single most important proposition in economic theory, first stated by Adam Smith, is that competitive markets do a good job allocating resources. Vilfredo Pareto’s later formulation was more precise than Smith’s, and also highlighted the dependence of Smith’s proposition on assumptions that may not be satisfied in the real world. The financial crisis has spurred a debate about the proper balance between markets and government and prompted some scholars to question whether the conditions assumed by Smith and Pareto are accurate for modern economies.
The single most important proposition in economic theory is that, by and large, competitive markets that are relatively, but generally not completely, free of government guidance do a better job allocating resources than occurs when governments play a dominant role. This proposition was first clearly formulated by Adam Smith in his classic Wealth of Nations. Except for some extreme supporters of free markets, today the preference for private markets is not an absolute. Almost everyone acknowledges that some functions, such as contract enforcement, cannot readily be delegated to market participants. The question is when and to what extent—not whether—private markets fail and therefore must be supplanted or regulated by government.
The answer to that question is something of a moving target, with views of the public and policymakers tending to ebb and flow. In much of the latter part of the 20th century, support for Smith’s pro-private-market verdict gained favor, as reflected in the partial deregulation of financial and nonfinancial markets in the 1980s and subsequent decades. The financial and economic debacle of the past few years, however, has led many to revisit this question, particularly in Europe, but also in the United States and elsewhere. To many, financial markets in the last several years appeared dysfunctional to an extent that was never imagined possible earlier. Did Adam Smith get it wrong about private markets?
This Economic Letter discusses two versions of the argument in favor of private markets: that of Adam Smith in the 18th century and that formulated in the 19th century by the Italian sociologist and economist Vilfredo Pareto. The discussion in this Letter points to the key assumptions in the arguments. Differing views on the degree of applicability of those assumptions underlie a good deal of the debate over the appropriate balance between relying on markets versus government intervention. Also important are views on the effectiveness of government involvement.
Competitive markets work: Adam Smith
In 17th and 18th century England prior to Smith it was taken for granted that economic and political leadership came from the king, not from private citizens. If the king wanted to initiate some large economic project, such as expanding trade with the colonies, he would encourage formation of a company to conduct that project, such as the East India Company. The king would grant that company a monopoly, usually in exchange for payment. Smith thought that these monopoly grants were a bad idea, and that instead private companies should be free to compete. He called on the king to discharge himself from a duty “in the attempting to perform which he must always be exposed to innumerable delusions, and for the proper performance of which no human wisdom or knowledge could ever be sufficient; the duty of superintending the industry of private people, and of directing it toward the employments most suitable to the interests of the society.” (Smith 1776 Book IV, Chapter 9)
Thus, Smith’s conclusion was that private markets worked better if they were free from government supervision, and for him it was just about that simple. Smith’s idea received its biggest challenge when the Soviet Union achieved world power status following World War II. In the 1960s, reported gross national product grew at much higher rates in the Soviet Union than in the United States or western Europe. Such authorities as the Central Intelligence Agency estimated that, before long, Soviet gross national product per capita would exceed that in the United States. To many, it looked as though centrally planned economies could achieve higher growth rates than market economies.
Economists who saw themselves as followers of Smith took issue. To them, it was simply not possible for centrally planned economies to achieve higher standards of living than market economies. As Smith put it, government could not be expected successfully to superintend the industry of private people. Too much information was required, and it was too difficult to structure the incentives. G. Warren Nutter, an economist at the University of Virginia, conducted a detailed study of the Soviet economy, arguing that the CIA’s estimates of Soviet output were much too high (Nutter 1962). At the time, those findings were not taken seriously. But, by the 1980s, we knew that Nutter had been correct. If anything, the Soviet Union was falling further and further behind. By 1990, this process came to its logical conclusion: the Soviet empire disintegrated. Score a point for Adam Smith.
Competitive markets work: Vilfredo Pareto
By the 19th century, economists had largely abandoned the informal and literary style of Smith in favor of the more precise—if less engaging—style of today’s economics. Increasingly, economists came to appreciate the role of formal mathematical model-building in enforcing logical consistency and clarity of exposition, although that development did not get into high gear until the 20th century. Under the leadership of Pareto and others, Adam Smith’s argument in favor of private competitive markets underwent a major reformulation.
Pareto’s version of the argument is usually taken to be a refinement of Smith’s. But, for the present purpose, it’s best to emphasize the differences rather than the similarities. First, Pareto provided a more precise definition than Smith of efficient resource allocation. An allocation is “Pareto efficient” if it is impossible to reallocate goods to make everyone better off. Or, to put it another way, you cannot make someone better off without making someone else worse off. This idea captures part of what we usually mean by “good performance,” but not all of it. For example, attaining a reasonably equal income distribution is often taken to be part of what we mean by good performance, but an equal income distribution is not an implication of Pareto efficiency. Indeed, public policies designed to reduce the degree of income inequality can involve redistribution of income, making some better off and others worse off. (See Yellen 2006 for a discussion of income inequality.)
Pareto reached the remarkable conclusion that competitive markets generate Pareto-efficient allocations. In competitive markets, prices measure scarcity and desirability, so the profit motive leads market participants to make efficient use of productive resources. The English economist F.Y. Edgeworth made a similar argument at about the same time as Pareto. Economists Kenneth Arrow and Gérard Debreu presented precise formulations of the Pareto-Edgeworth result in the 1950s and 1960s.
A mathematical proof that competitive allocations are Pareto efficient required a characterization of a competitive economy that is more precise than anything Smith had provided. For Pareto, unlike Smith, it was not enough that the economy be free of government intervention. The essential characteristic for Pareto was that a buyer’s payment and a seller’s receipts from any transaction be in strict proportion to the quantity transacted. In other words, individuals cannot affect prices. This assumption is satisfied, to a close approximation, by the classical competitive markets, such as those for corn, wheat, and other agricultural commodities. The assumption rules out monopoly and monopsony, in which individual sellers and buyers are large enough to be able to manipulate prices by altering quantities supplied or demanded. When monopolists and monopsonists can distort prices in this way, allocations will not be Pareto efficient.
Pareto’s efficiency result was first formulated in mathematical models of economies that were static and deterministic—that is, models in which time and uncertainty were not explicitly represented. In the 20th century, economists realized that the validity of the Pareto-efficiency result does not depend on these extreme restrictions. Arrow and Debreu showed that allocations will be Pareto efficient even in economies in which time and uncertainty are explicitly represented. They showed that, in any economy, there is an irreducible minimum level of risk that somebody has to bear. In a competitive economy with well-functioning financial markets, this risk will be borne by those who are most risk tolerant and who therefore require the least compensation in terms of higher expected return for bearing the risk. This is exactly as one would expect—risk-tolerant participants use financial markets to insure the risk averse. These aspects of equilibrium are discussed in standard texts on financial economics (such as LeRoy and Werner 2001).
However, demonstrating these results mathematically depends on assuming symmetric information—that is, assuming that everyone has unrestricted access to the same information. Such an assumption is less unrealistic than excluding uncertainty altogether, but it is still a strong restriction. The advent of game theory in recent decades has made it possible to relax the unattractive assumption of symmetric information. But Pareto efficiency often does not survive in settings that allow for asymmetric information. Based on mathematical economic theory, then, it appears that the argument that private markets produce good economic outcomes is open to serious question.
Nonmathematical economists such as Friedrich Hayek proposed an argument for the superiority of market systems that did not depend on Pareto efficiency. In fact, Hayek’s argument was the exact opposite of that of Arrow and Debreu. For him, it was the existence of asymmetric information that provided the strongest rationale in favor of market-based economic systems. Hayek emphasized that prices incorporate valuable information about desirability and scarcity, and the profit motive induces producers and consumers to respond to this information by economizing on expensive goods. He expressed the view that economies in which prices are not used to communicate information—planned economies, such as that of the Soviet Union—could not possibly induce suppliers to produce efficiently. This is essentially the same as the argument against socialism discussed above.
Reevaluating the balance between markets and the government
The financial crisis that we have just experienced puts the question about the appropriate balance between reliance on markets and government intervention on center stage. Those who believe that unregulated markets generally work well express the view that misconceived interference by the government was the major cause of the crisis. In contrast, those who take a more critical view about the functioning of private markets believe that the crisis stemmed mainly from the destructive consequences of factors such as information asymmetries in financial markets and distortions to incentives that encouraged excessive risk-taking. The problem was not government involvement per se, but rather government’s failure to place checks on destructive market practices.
This latter view dominates most of the recent proposals for financial reform. And, while the particulars of financial reform are still to be determined, it appears that current sentiment is less supportive of Adam Smith’s verdict on the efficiency of markets than was the case prior to the financial crisis. At the same time, it seems clear that neither extreme view of the causes of the financial crisis is accurate. Reforms based only on one of these views to the exclusion of the other will not lead to a set of changes that will guarantee improvement of the performance of financial markets and prevent recurrence of financial crisis. The problems are complex, and sweeping changes in the regulatory structure could do more harm than good. A better strategy may be to identify specific problems in the financial system and introduce regulatory changes that address these clearly defined weaknesses, such as executive compensation practices that encourage excessive risk-taking.

In response, I'll point, once again, to Markets Are Not Magic which makes the point that for all of the nice properties identified by Pareto and others to hold, having markets that are free of government intervention is not enough. To obtain optimality, markets must be competitive, and a competitive marketplace requires some fairly restrictive assumptions to hold, assumptions that, in many cases, can only be satisfied with government intervention.

When it comes to government intervention, the one thing I wish people would understand is the difference between free markets and competitive markets. Markets that are free of government oversight are also free to exploit consumers in a variety of ways, from fraud to higher than necessary prices. Markets that are free, but not competitive, do not necessarily result in the best possible outcome.

When problems do exist, we should still ask if government intervention will actually help, but I believe we have been far too cautious in intervening to solve market failures. For example, as I've discussed many times, obvious market failures exist at almost every stage of mortgage markets, from the real estate agent, appraisers, and loan originators all the way through the securitization process. Somehow, we were led to believe that these failures that were so profitable to those able to exploit them would fix themselves. But they don't, and didn't, and the belief that they would caused us to stand by and do nothing as these markets departed further and further from the competitive ideal.

Hopefully we've learned something about the need for government oversight and intervention to correct problems, but it's not yet clear that we have. In coming months, we will see an attempt by market fundamentalists to tell a story about the economy recovering on its own despite government intervention. We'll hear all about the miraculous self-healing properties of the economy, and we will be told that it would have been even more miraculous if the government would have stayed out of the way.

When they try to sell you this story, remember that these are many of the same people who went to the government, hat in hand, begging for the government to give them the help they needed to save their too big to fail bank (OK, maybe the hats weren't in hand, maybe they demanded a bailout with the economy held hostage, but the point is that they wanted and needed the bailout). Their arguments are self-serving, just as Adam Smith said they'd be, and your interests are not the primary concern of the people trying to resist stricter government regulation and oversight of the financial industry. You'd be well advised not to buy the market fundamentalism they'll be selling.

Sunday, May 02, 2010

"The 'Real' Causes of China’s Trade Surplus"

Zheng Song, Kjetil Storesletten, and Fabrizio Zilibotti argue, based upon their forthcoming AER article, that although China has accumulated nearly two and a half trillion in reserves in the last two decades, "it is wrong, and even dangerous, to blame this on a manipulation of the exchange rate." They argue that the existence of credit market imperfections leading to the need for high levels of internal savings provides a better explanation:

The “real” causes of China’s trade surplus, by Zheng Song, Kjetil Storesletten, and Fabrizio Zilibotti, Vox EU: Over the last two decades, China has run large trade surpluses. Its foreign reserves swelled from $21 billion in 1992 (5% of its annual GDP) to $2.4 trillion in June 2009 (close to 50% of its GDP). The effect of this gigantic build up of reserves has been a source of growing public attention in the context of the debate on global imbalances. This debate has gained momentum during the global crisis. Lobbyists and politicians voice the popular concern that by swamping western markets with its products, China contributes to the failure of domestic firms and job losses. The call for protectionism is mounting.

Did China engineer a trade surplus?

A common argument, especially in the US, is that the culprit of global imbalances is the exchange rate manipulation carried out by the Chinese authorities, who peg the renminbi to the dollar at a low value. According to Fred Bergsten, head of the Peterson Institute for International Economics, the renminbi is undervalued by at least 25% to 40%. This "hostile" policy raises calls for robust retaliation.

While economists have so far opposed any measure that might ignite a vicious cycle of trade retaliations and protectionism, even their front is cracking. Krugman (2010) advocated using the threat of a 25% import surcharge to force China to revalue. Last month, 130 lawmakers signed a letter asking the US Treasury to increase tariffs on Chinese-made imports. On 12 April 2010, Barack Obama openly criticized the Chinese exchange-rate policy in front of Hu Jintao, arguing that currencies should "roughly" track the market so that no country has an advantage in trade. Meanwhile, Senator Charles Schumer called for high tariffs against Chinese imports in order to force Beijing to revalue its currency.

The exchange rate manipulation premise

The manipulation thesis rests on the simple postulate that the imbalance itself is evidence of a misalignment of the exchange rate. Letting market forces determine the exchange rate would restore trade balance.

This argument has weak foundations. What matters is the real exchange rate, not the nominal one. While the Chinese surplus has persisted for almost two decades, the real exchange rate has remained as flat as a pancake (see McKinnon 2006, Figure 3). A misaligned real exchange rate should feed domestic inflation, e.g., by increasing the demand of non-traded goods and stimulating domestic wage pressure. Yet, until very recently it does not appear as if China has experienced any major inflationary pressure – between 1997 and 2007 the inflation rate was on average about the same as in the US. Moreover, wages have grown slower than output per worker (see Banister 2007).

In a recent article on this site, Helmut Reisen (2010) shows that a large part of the alleged undervaluation of the renminbi can be attributed to the Balassa-Samuelson effect (i.e., the fact that non-traded goods do not follow the law of one price and are relatively cheap in developing countries). He concludes that "the undervaluation in 2008 of the renminbi was only 12% against the regression-fitted value for China's income level." This is by no means a large number: “Both India and South Africa (which had a current-account deficit) were more undervalued in 2008.” In summary, while it is reasonable to expect some appreciation of the real exchange rate in the years to come (through either inflation or adjustments in the nominal exchange rate), the government manipulation of the nominal exchange rate is unlikely to be the primary cause of the two-decades-long imbalance.

A “real” explanation: Growing like China

What, then, can account for the Chinese surplus? We believe that the answer lies in real (i.e., structural) factors rather than in nominal rigidities. Let us look at the imbalance from an asset flow perspective: 

Continue reading ""The 'Real' Causes of China’s Trade Surplus"" »

Monday, April 26, 2010

Is Market Fundamentalism the Easier Argument?

This is probably a "grass is greener on the other side" argument, but when I listen to market fundamentalists argue for their side, as many have so far today in the sessions I've attended at the Milken Global Conference, I get envious. It's such an easy argument to make. No matter what the problem, the solution -- though stated in many, many creative ways -- is always the same. Get government out of the way and let markets do their magic. A tax cut, a reduction in government spending, or easing of regulation will always make things better, not worse. And if there are problems in markets, they can always be blamed on government. Even when fundamentalists admit there is a market failure because it cannot be denied, they can (and do) argue that the government will still make things worse if it intervenes. Thus, no matter the problem, there is always a simple explanation and a simple solution. When you argue for government intervention, the job is much harder. You have to identify the specific market failure, argue that it's significant enough to justify government intervention, come up with a policy that will address the particular failure without making other things worse, and then argue that the political process won't mangle the policy so badly as to make it worthless or counterproductive.

I don't have a problem with the baseline assumption being that we should leave markets alone unless it can be demonstrated that significant problems exist, and that there's a chance of making things better, but the deck does seem to be stacked against the interventionist position.

Paul Krugman: Berating the Raters

Paul Krugman continues the discussion on the problems with the ratings agencies, and the failure of congress to do anything about it:

Berating the Raters, by Paul Krugman, Commentary, NY Times: Let’s hear it for the Senate’s Permanent Subcommittee on Investigations. Its work on the financial crisis is increasingly looking like the 21st-century version of the Pecora hearings, which helped usher in New Deal-era financial regulation. In the past few days scandalous Wall Street e-mail messages released by the subcommittee have made headlines.
That’s the good news. The bad news is that most of the headlines were about the wrong e-mails. When Goldman Sachs employees bragged about the money they had made by shorting the housing market, it was ugly, but that didn’t amount to wrongdoing.
No, the e-mail messages you should be focusing on are the ones from employees at the credit rating agencies, which bestowed AAA ratings on hundreds of billions of dollars’ worth of dubious assets, nearly all of which have since turned out to be toxic waste. And no, that’s not hyperbole: of AAA-rated subprime-mortgage-backed securities issued in 2006, 93 percent — 93 percent! — have now been downgraded to junk status.
What those e-mails reveal is a deeply corrupt system ... that financial reform, as currently proposed, wouldn’t fix.
The rating agencies ... play a central role in our whole financial system, especially for institutional investors like pension funds, which would buy your bonds if and only if they received that coveted AAA rating.
It was a system that looked dignified and respectable on the surface. Yet it produced huge conflicts of interest. Issuers of ... securities ... could choose among several rating agencies. So they could direct their business to whichever agency was most likely to give a favorable verdict, and threaten to pull business from an agency that tried too hard to do its job. It’s all too obvious, in retrospect, how this could have corrupted the process.
And it did. The Senate subcommittee has focused its investigations on the two biggest credit rating agencies, Moody’s and Standard & Poor’s; what it has found confirms our worst suspicions. In one e-mail message, an S.& P. employee explains that a meeting is necessary to “discuss adjusting criteria” for assessing housing-backed securities “because of the ongoing threat of losing deals.” Another message complains of having to use resources “to massage the sub-prime and alt-A numbers to preserve market share.” Clearly, the rating agencies skewed their assessments to please their clients.
These skewed assessments, in turn, helped the financial system take on far more risk than it could safely handle. ...
So what can be done to keep it from happening again?
The bill now before the Senate tries to do something..., but all in all it’s pretty weak... The only provision that might have teeth is one that would make it easier to sue rating agencies if they engaged in “knowing or reckless failure” to do the right thing. But that surely isn’t enough...
What we really need is a fundamental change in the raters’ incentives..., something ... to end the fundamentally corrupt nature of the the issuer-pays system.
An example of what might work is a proposal by Matthew Richardson and Lawrence White of New York University ... in which firms issuing bonds continue paying rating agencies to assess those bonds — but ... the Securities and Exchange Commission, not the issuing firm, determines which rating agency gets the business.
I’m not wedded to that particular proposal. But doing nothing isn’t an option. It’s comforting to pretend that the financial crisis was caused by nothing more than honest errors. But it wasn’t; it was, in large part, the result of a corrupt system. And the rating agencies were a big part of that corruption.

Saturday, April 24, 2010

A Formula for Gaming the Ratings Agencies

It looks like it wasn't too hard to game the formula the ratings agencies used to evaluate bonds:

Rating Agency Data Aided Wall Street in Mortgage Deals, by Gretchen Morgenson and Louise Story, NY Times: One of the mysteries of the financial crisis is how mortgage investments that turned out to be so bad earned credit ratings that made them look so good.
One answer is that Wall Street was given access to the formulas behind those magic ratings — and hired away some of the very people who had devised them.
In essence, banks started with the answers and worked backward, reverse-engineering top-flight ratings for investments that were, in some cases, riskier than ratings suggested...
The rating agencies made public computer models that were used to devise ratings to make the process less secretive. That way, banks and others issuing bonds — companies and states, for instance — wouldn’t be surprised by a weak rating that could make it harder to sell the bonds or that would require them to offer a higher interest rate.
But by routinely sharing their models, the agencies in effect gave bankers the tools to tinker with their complicated mortgage deals until the models produced the desired ratings.
“There’s a bit of a Catch-22 here, to be fair to the ratings agencies,” said Dan Rosen, a member of Fitch’s academic advisory board and the chief of R2 Financial Technologies in Toronto. “They have to explain how they do things, but that sometimes allowed people to game it.” ...
But for Goldman and other banks, a road map to the right ratings wasn’t enough. Analysts from the agencies were hired to help construct the deals. ... For example, a top concern of investors was that mortgage deals be underpinned by a variety of loans. Few wanted investments backed by loans from only one part of the country or handled by one mortgage servicer.
But some bankers would simply list a different servicer, even though the bonds were serviced by the same institution, and thus produce a better rating... Others relabeled parts of collateralized debt obligations in two ways so they would not be recognized by the computer models as being the same...
Banks were also able to get more favorable ratings by adding a small amount of commercial real estate loans to a mix of home loans, thus making the entire pool appear safer.
Sometimes agency employees caught and corrected such entries. Checking them all was difficult, however. “If you dug into it, if you had the time, you would see errors that magically favored the banker,” said one former ratings executive... “If they had the time, they would fix it, but we were so overwhelmed.”

There are two problems that need to be fixed. The first is the incentive that ratings agencies have to give high ratings, and the second is the gaming of the ratings formula described above

The first problem, the incentive to provide high ratings, arises because the firm paying to have the financial asset evaluated also picks the ratings agency. A reputation as a tough rater is not good for future business, so there is an incentive for the agency to provide the rating the company is looking for. There are a variety of ways to fix this, e.g. a third party selects the particular agency that will do the rating (so that low rating does not affect the probability of being selected in the future), but so far Congress has not proposed the needed reform.

The second problem, the gaming of the ratings formula, is also helped by having a third party select the ratings agency. When the company gets to select the ratings agency itself, it can craft a strategy to precisely take advantage of the formula used by that agency. But if each company has different strengths and weaknesses, and any company could be selected by the third party, it won't be as easy to know which particular game to play. If the wrong agency is chosen, the result could be a lower than expected rating. This doesn't stop all potential gaming, for example a common flaw across all ratings agencies can still be exploited, but it does make it generally harder to game the system.

I don't think ratings agencies were the root cause of the financial crisis, but they did make it much, much worse by allowing so many highly rated but actually toxic assets onto the balance sheets of financial institutions. There is a need to fix the ratings agency problem, but as noted above there has been no action from Congress on this issue. Perhaps the recent attention to the role the ratings agencies played in the crisis will change that, but I'm certainly not counting on it.

Wednesday, April 21, 2010

Why Did Bad Bonds Get Good Ratings?

When I was asked what was missing from the proposed financial reform legislation, I should have mentioned the lack of effective reform measures for ratings agencies, particularly the incentive to provide high ratings to encourage future business. As noted below, part of the reform legislation is directed at the ratings agencies, but it doesn't get at the main problem, which is the incentive to tell its customers what they want to hear, i.e. the incentive to deliver higher ratings than deserved. For some reason ($$$???), the ratings agencies seem to be escaping the legislative and regulatory attention they ought to be receiving:

Senate to ask Moody's chief why bad bonds got good ratings, by Kevin G. Hall, McClatchy Newspapers: ...On Friday, Moody's CEO Raymond McDaniel Jr. will face the Senate Permanent Subcommittee on Investigations, which is looking into the role the credit-rating agencies played in the ... financial crisis...

McDaniel has yet to face the kind of congressional grilling already suffered by bank executives. However, an earlier hearing revealed a transcript in which McDaniel told his board of directors that his firm was constantly pressured to inflate ratings — and that sometimes Moody's "drank the Kool-Aid." ...

Legislation to revamp financial regulations threatens to leave them more open to lawsuits for bad ratings, although not as open as consumer advocates hoped. ...

The special role of the ratings agencies was underscored last Friday when the Securities and Exchange Commission brought civil fraud charges against Goldman Sachs. The SEC alleges that Goldman failed to disclose vital information to investors... Goldman's alleged deception of investors may have extended to the ratings agencies. ... However, even if the ratings agencies were duped, their participation in these complex deals gives the appearance of complicity. At minimum, Goldman and its competitors had a symbiotic relationship with the ratings agencies. ...

[I]n a McClatchy investigation late last year, former Moody's officials recounted how Wall Street investment powers like Goldman played the three major ratings agencies off each other to get the ratings they needed to attract investors. The carrot for the ratings agencies was a big reward, $1 million or more, for providing an investment grade to a complex deal.
Moody's dominated the rating of "structured-finance products"... Chief among these were collateralized debt obligations and mortgage-backed securities ... that were sold to investors. Institutional investors such as pension funds ... are often restricted to purchasing only investment-grade securities, so Wall Street worked feverishly to win investment grades from Moody's or its competitors, Standard & Poor's and Fitch. ...
Moody's ... ratings quality eroded as analysts were under intense pressure from ... McDaniel to maintain market share and a "business-friendly" environment. ...

Perhaps the Senate hearing on Friday will begin to raise awareness of the problems with ratings agencies and prompt legislative and regulatory remedies, but given the lack of scrutiny so far, I'm certainly not counting on it.

Tuesday, April 20, 2010

Concentration of the US Banking System


As noted in the post below this one, I don't think bank size and stability of the banking system are closely related, we still had financial meltdowns in the days when banks were small. But I do think bank size and political power are highly correlated, and that banks have far too much political influence. So the question is, why do banks need to be so much bigger today? If we were to cut the share of total commercial banking sector assets held by the top three banks back to its historical average of 10-15%, which still seems relatively concentrated, would that be a disaster? I certainly haven't seen convincing evidence that economies of scale require banks to be this large, so why allow it?

Sunday, April 18, 2010

"The Case Against Gene Patents"

Joseph Stiglitz and John Sulston argue that "the patenting of human genes is wrong."

[I've been sitting on this post for a couple of days hoping to think of something to say about it, but haven't come up with much. One of the main ideas is that patents are not the only way to solve the market failure associated with innovative activity (the problem is the inability to stop others from taking advantage of your investment in research). An alternative is "government- and foundation-supported research in universities and research laboratories," and they prefer this alternative when "basic knowledge" is involved. I like this idea, but I'm not sure how "basic knowledge" should be defined.]:

The Case Against Gene Patents, by Joseph Stiglitz and John Sulston, Commentary, WSJ: Last month, a federal court in New York ... ruled that patents were improperly granted to Myriad Genetics on two human genes associated with hereditary breast and ovarian cancer. We participated in the case supporting the plaintiffs ... because we believe the patenting of human genes is wrong as a matter of science and as a matter of economics. ...
The court held that genes and human genetic sequences are naturally occurring things, not inventions. They ... contain the most fundamental information about humanity—information that should be available to everyone. The researchers and private companies that applied for these gene patents did not invent the genes; they only identified what was already there.
Proponents of gene patents argue that private companies will not engage in genetic research unless they have the economic incentives created by the patent system. We believe ... exactly the opposite... Patents such as those in this case not only prevent the use of knowledge in ways that would most benefit society, they may even impede scientific progress. ...
As we move into an era where the sequencing of all of an individual's genes is common and necessary for personalized medicine,..., the basic data must be freely available to everyone to interpret and develop. Our genetic makeup is far too complicated for a single entity to hold the keys to any given gene and to be able to choose when, if ever, to share.
Patents are also not necessary for ensuring that genetic tests come to market. Currently, Myriad does not allow any other lab ... to perform full diagnostic testing on patients ... at increased risk of hereditary breast and ovarian cancer. Because of this monopoly, Myriad is able to charge more than $3,000 to perform the test, a prohibitively high amount that keeps some women from being tested...
Other labs have said they would be willing to perform the test for a few hundred dollars,... and could also develop new tests... The information provided by the tests is of enormous importance: The lifetime risk of getting breast cancer is as high as 85% for mutation carriers.
Any marginal social benefits of patenting genes clearly do not measure up to the profound costs of locking down knowledge. ... Like basic mathematical theorems, genes are an example of "basic knowledge"—the kind of knowledge that typically cannot and should not be patented. ... It's true that knowledge cannot be produced without cost, but there is a proven alternative: government- and foundation-supported research in universities and research laboratories. ...
We see this ruling as a turning point in our thinking about our patent system, and more broadly, scientific research.

They say that patenting of human genes is wrong "as a matter of science and as a matter of economics." Economics and science don't deal well with this, but ethics might be involved as well.

One thing I'm confused about in the article is the difference between patenting the genes and patenting the test that looks for them. I understand why genes shouldn't be patented, but what about the test? If a company develops a life-saving test for a genetic disorder, but decides to use a patent to charge monopoly prices that exclude many people from taking the test, how should we respond? Give subsidies to those who can't afford it? Define it as basic research and outlaw the patent? Do nothing and let the market decide? We don't want to discourage the research that produced the test, but we don't want to exclude people either, so a new model is needed for these cases. The question for me is whether "government- and foundation-supported research in universities and research laboratories" provides the correct incentives. It does solve the patent/monopoly prices problem, but will it produce the research we need?

Another alternative is for the government to offer prizes for significant discoveries, e.g. for new, important drugs, but it's not clear to me that government can design the correct incentive system particularly in areas where we know little about which direction to proceed. As Sitglitz notes elsewhere:

Of course, the patent system is itself a prize system, albeit a peculiar one: the prize is temporary monopoly power, implying high prices and restricted access to the benefits that can be derived from the new knowledge. By contrast, the type of prize system I have in mind would rely on competitive markets to lower prices and make the fruits of the knowledge available as widely as possible. With better-directed incentives (more research dollars spent on more important diseases, less money spent on wasteful and distorted marketing), we could have better health at lower cost.

That said, the prize fund would not replace patents. It would be part of the portfolio of methods for encouraging and supporting research. A prize fund would work well in areas in which needs are well known – the case for many diseases afflicting the poor – allowing clear goals to be set in advance. For innovations that solve problems or meet needs that have not previously been widely recognized, the patent system would still play a role.


The market economy and the profit motive have led to extremely high living standards in many places. But the health care market is not an ordinary market. Most people do not pay for what they consume; they rely on others to judge what they should consume, and prices do not influence these judgments as they do with conventional commodities. The market is thus rife with distortions. It is accordingly not surprising that in the area of health, the patent system, with all of its distortions, has failed in so many ways. A medical prize fund would not provide a panacea, but it would be a step in the right direction, redirecting our scarce research resources toward more efficient uses and ensuring that the benefits of that research reach the many people who are currently denied them.

Stiglitz calls for a "portfolio of methods," and perhaps that's the best we can do. But once a portfolio approach including patents is adopted big business, e.g. the pharmaceutical industry, can use its power to distort the portfolio choice in its favor. Thus, the portfolio approach requires countervailing power, power that does not exist in sufficient quantity. Unchecked, the portfolio approach would likely end up looking much like the system we already have, so it's not clear to me that this is the answer.

Wednesday, April 07, 2010

"Doctors with Ownership in Surgery Center Operate More Often"

Are you surprised to find out that there is evidence suggesting that doctor's with a financial stake in surgery centers do more surgery?:

Doctors with ownership in surgery center operate more often, U-M study finds, EurekAlert: When doctors become invested in an outpatient surgery center, they perform on average twice as many surgeries as doctors with no such financial stake, according to a new study from the University of Michigan Health System.
"Our data suggest that physician behavior changes after investment in an outpatient facility. Through what some have labeled the 'triple dip,' physician owners of surgery centers not only collect a professional fee for the services provided, but also share in their facility's profits and the increased value of their investment. This creates a potential conflict of interest," says study author John Hollingsworth, M.D., M.S., a Robert Wood Johnson Clinical Scholar at the U-M Medical School.
"To the extent that owners are motivated by profit, one potential explanation for our findings is that these physicians may be lowering their thresholds for treating patients with these common outpatient procedures," Hollingsworth adds.
The study looked at all patients in Florida who underwent one of five common outpatient procedures: carpal tunnel release, cataract excision, colonoscopy, knee arthroscopy and myringotomy with tympanostomy tube placement (a procedure to insert tubes in the ear).
The researchers determined which doctors were owners of a surgery center. They then compared surgery use among owners in two time periods—before and after they acquired ownership—with that of physicians who remained non-owners.
Results of the study appear in the April issue of Health Affairs. The findings include:
Owners operated on an average of twice as many patients as non-owners. While caseloads increased overall between the earlier and later time periods for all physicians, the increases were more rapid and dramatic among owners.
The number of surgery centers has increased nearly 50 percent over the last decade, largely driven by the investment of physicians, who had a stake in 83 percent of these facilities. For doctors, investment may give them more control over their practice environment, from scheduling cases to purchasing surgical equipment. For patients, these centers often have shorter wait times than hospitals and may provide more amenities.

"There are some definite advantages for surgeons, as well as patients, associated with care at surgery centers. However, we need to better understand the implications of these new findings, in particular their overall effect on health care expenditures. Insofar as our results are due to lowered treatment thresholds, policymakers should consider, at the very least, requiring all physicians to disclose their financial interests to their patients," Hollingsworth says.

[Traveling here today - this should post automatically while I'm in the air...]

Imperfect Competition in "Transparency Services"

The lack of competition in markets for "transparency services" is a problem:
The Lehman bankruptcy examiner report: And then there were none, by Michael Pomerleano, Economist's Forum: What are the broader implications of the report on Lehman Brothers issued by the bankruptcy examiner?
The report details the effort to conceal Lehman’s true debt levels through the so-called “Repo 105” structure. It finds “credible evidence” to back a claim that the failure of Dick Fuld, Lehman chief executive, to disclose the transactions was “grossly negligent”.
Anton Valukas, the report’s author, also found that there was sufficient evidence to back a claim that Mr Fuld and other executives breached their fiduciary duties by “allowing and certifying the filing of financial statements that omitted or misrepresented material information”. ...
The broader implications of this case are serious and will have lasting impact. First, transparency is at the foundation of a well-functioning system, and it relies on multiple gatekeepers such as accountants, auditors, lawyers, and rating agencies. However, instead of developing a competitive, transparent system of gatekeepers, we are witnessing the shrinking of the global gatekeepers industry. ...
We are witnessing increased concentration in a form of imperfect competition in which a large number of buyers face a very small number of sellers of “transparency” services. Clearly this market structure is prone to distortions. We are down to four big national accounting firms and three rating agencies. The rating agencies and accounting firms know that they have the regulators and financial industry over a barrel... This situation is not conducive to reforms.
A second and more troublesome problem is the incoherence in international financial regulation, which has permitted a race to the bottom in a process of regulatory arbitrage designed to maintain the hegemony of London as a financial center. ... As long as this global regulatory arbitrage continues, the forces of competition may force the most “straight-laced” financial firms, auditors, lawyers, and rating agencies to compromise their sound judgment.
The credit rating agencies and accounting firms have played a critical role in the debacle of the past two years. As a result, we are witnessing efforts to heighten regulation of the rating agencies... It is my hope that the authorities on both sides of the Atlantic will investigate the culpability of lawyers and accountants and, if found guilty, pursue action to the full extent permissible by the law. ...

The proposed financial reform legislation doesn't do much to address the problems in the ratings agencies. That's been one of the disappointing aspects of the financial reform effort. As for accounting firms, more competition couldn't hurt, and yes, we should prosecute fraud, but the more general problem of establishing reporting principles that cannot be gamed, that convey information accurately, etc. is tougher. Any ideas?

Thursday, April 01, 2010

Corporations, Social Insurance, and Unchecked Power

James Madison was not a fan of corporations:

Early Americans had a far more comprehensive and nuanced understanding of corporations than the Court gives them credit for. They were much more comfortable with retaining pre-Revolutionary city or school charters than with creating new corporations that would concentrate economic and political power in potentially unaccountable institutions. When you read Madison in particular, you see that he wasn't blindly hostile to banks during his fight with Alexander Hamilton over the Bank of the United States. Instead, he's worried about the unchecked power of accumulations of capital that come with creating a class of bankers.

More here: What the Founding Fathers Really Thought About Corporations, by Justin Fox. [See also: The Founders were deeply skeptical of corporations, by Michael Giberson.]

When thinking about corporations, I think it's useful to keep this in mind:

David A. Moss, a Harvard Business School professor ... explains that the first application of social insurance in our latitudes actually was aimed ... at ... supporting the growth of modern capitalism. Its main instrument to that end was the legal sanction of the principle of limited liability of the owners of corporations.
Prior to this form of social insurance, the owners of a business were legally liable with their personal wealth for damages the business might have inflicted on others. With limited liability, the corporation’s shareholders are liable only up to their equity stake in the company. ... Beyond that, someone else in society — often the taxpayer — bears the financial risk for damages attributable to the corporation.
One wonders how many business executives and members of chambers of commerce ... realize that the limited liability of shareholders is social insurance.

In return for this protection, it's not unreasonable to impose regulation on corporations that, should they fail, impose large damages on society that do not have to be paid be the owners and managers. (As is the case with too big too fail financial institutions, e.g. do you think the behavior of banks might have been different if the bank managers' personal assets were at stake in a bank failure, with a high likelihood that bank failure would leave the managers penniless? In the current financial meltdown that was so costly to society, many managers paid little penalty when the firms they managed failed.)

For a managers and owners, if failure in the future is likely, the game here is simple. Transfer as much wealth as possible as fast as possible from the corporation to managers/owners where it will be safe from creditors and others who face costs if and when the corporation fails.

I'm not suggesting an end to limited liability -- though clawback provisions that return assets to the corporation are needed to give managers an incentive to maximize long-run rather than short-run gains and to prevent the looting of troubled firms. Only that the regulation of firms that benefit from substantial amounts of implicit social insurance is needed to align the incentives of managers with stockholders and, more generally, society at large.

Wednesday, March 24, 2010

What Market Discipline?

How much did executives at Bear Stearns and Lehman Brothers lose as a result of the financial crisis?:

Paid to Fail, by Lucian Bebchuk, Alma Cohen, and Holger Spamann, Commentary, Project Syndicate: ...Lehman’s executives made deliberate decisions to pursue an aggressive investment strategy, take on greater risks, and substantially increase leverage. Were these decisions the result of hubris and errors in judgment or the product of flawed incentives?
After Bear Stearns and Lehman Brothers melted down, ushering in a worldwide crisis, media reports largely assumed that the wealth of these firms’ executives was wiped out, together with that of the firms they navigated into disaster. This “standard narrative” led commentators to downplay the role of flawed compensation arrangements and the importance of reforming the structures of executive pay.
In our study, “The Wages of Failure: Executive Compensation at Bear Stearns and Lehman Brothers 2000-2008,” we examine this standard narrative and find it to be incorrect. We ... find that,... during 2000-2008, the top five executives at Bear Stearns and Lehman pocketed about $1.4 billion and $1 billion, respectively, or roughly $250 million per executive. These cash proceeds are substantially higher than the value of the holdings that the executives held at the beginning of the period. Thus, while the long-term shareholders in their firms were largely decimated, the executives’ performance-based compensation kept them in positive territory.
The divergence between how top executives and their companies’ shareholders fared raises a serious concern that the aggressive risk-taking at Bear Stearns and Lehman – and other financial firms with similar pay arrangements – could have been the product of flawed incentives. ...
It is important for financial firms – and firms in general – to reform compensation structures to ensure tighter alignment between executive payoffs and long-term results. ...
Had such compensation structures been in place at Bear Stearns and Lehman, their top executives would not have been able to derive such large amounts of performance-based compensation for managing the firms in the years leading up to their collapse. This would have significantly reduced the executives’ incentives to engage in risk-taking.
Indeed,... comprehensive and robust reform of pay structures ... could do a great deal to improve incentives and prevent the type of excessive risk-taking that firms encouraged in the years preceding the financial crisis... Reforms that redress these destructive incentives should stand as an important lesson and legacy of Bear Stearns, Lehman Brothers, and the crisis they helped to fuel.

Sunday, March 21, 2010

"Toward a More Competitive, Efficient, and Innovative Financial System"

In a speech today, Ben Bernanke says the financial system is far from the "competitive ideal," and that the too-big-to-fail problem is the primary cause of the "insidious barriers to competition" and "competitive inequities" that currently exist in these markets.

One thing I'd add is that there is reason to be concerned about the size of these firms over and above the too-big-to-fail problem, i.e. for traditional reasons involving the exercise of market power. Bernanke says that:

our technologically sophisticated and globalized economy will still need large, complex, and internationally active financial firms to meet the needs of multinational firms, to facilitate international flows of goods and capital, and to take advantage of economies of scale and scope

But I'd like to have more precise information about how large these firms need to be until the economies of scope and scale begin bottoming out. If it's so large that firms can gain a substantial market share by moving down the cost curve, then regulators need to ensure that firms do not exploit their market power:

...Toward a More Competitive, Efficient, and Innovative Financial System The United States has a financial system that is remarkably multifaceted and diverse. Some countries rely heavily on a few large banks to provide credit and financial services; our system, in contrast, includes financial institutions of all sizes, with a wide range of charters and missions. We also rely more than any other country on an array of specialized financial markets to allocate credit and help diversify risks. Our system is complex, but I think that for the most part its variety is an important strength. We have many, many ways to connect borrowers and savers in the United States, and directing saving to the most productive channels is an essential prerequisite to a successful economy.
That said, for the financial system to do its job well, it must be an impartial and efficient arbiter of credit flows. In a market economy, that result is best achieved through open competition on a level playing field, a framework that provides choices to consumers and borrowers and gives the most innovative and efficient firms the chance to succeed and grow. Unfortunately, our financial system today falls substantially short of that competitive ideal.
Among the most serious and most insidious barriers to competition in financial services is the too-big-to-fail problem. Like all of you, I remember well the frightening weeks in the fall of 2008, when the failure or near-failure of several large, complex, and interconnected firms shook the financial markets and our economy to their foundations. ... It is unconscionable that the fate of the world economy should be so closely tied to the fortunes of a relatively small number of giant financial firms. If we achieve nothing else in the wake of the crisis, we must ensure that we never again face such a situation.
The costs to all of us of having firms deemed too big to fail were stunningly evident during the days in which the financial system teetered near collapse. But the existence of too-big-to-fail firms also imposes heavy costs on our financial system even in more placid times. Perhaps most important, if a firm is publicly perceived as too big, or interconnected, or systemically critical for the authorities to permit its failure, its creditors and counterparties have less incentive to evaluate the quality of the firm's business model, its management, and its risk-taking behavior. As a result, such firms face limited market discipline, allowing them to obtain funding on better terms than the quality or riskiness of their business would merit and giving them incentives to take on excessive risks.
Having institutions that are too big to fail also creates competitive inequities that may prevent our most productive and innovative firms from prospering. In an environment of fair competition, smaller firms should have a chance to outperform larger companies. By the same token, firms that do not make the grade should exit, freeing up resources for other uses. Our economy is not static, and our banking system should not be static either.
In short, to have a competitive, vital, and innovative financial system in which market discipline encourages efficiency and controls risk, including risks to the system as a whole, we have to end the too-big-to-fail problem once and for all. But how can that be done? Some proposals have been made to limit the scope and activities of financial institutions, and I think a number of those ideas are worth careful consideration. Certainly, supervisors should be empowered to limit the involvement of firms in inappropriately risky activities. But even if such proposals are implemented, our technologically sophisticated and globalized economy will still need large, complex, and internationally active financial firms to meet the needs of multinational firms, to facilitate international flows of goods and capital, and to take advantage of economies of scale and scope. The unavoidable challenge is to make sure that size, complexity, and interconnectedness do not insulate such firms from market discipline, potentially making them ticking time bombs inside our financial system.
To address the too-big-to-fail problem, the Federal Reserve favors a three-part approach.

Continue reading ""Toward a More Competitive, Efficient, and Innovative Financial System"" »

Tuesday, March 09, 2010

Make Markets Be Markets

(clearer version of the graph in the presentation)

Here's the full set of videos from the conference:

Thursday, March 04, 2010

"A New Age of Monopolies"

Monopoly power was a much bigger concern in the past than it is today. Why aren't people more concerned about this?:

A New Age of Monopolies, by Thomas frank, Commentary, WSJ: ...Barry C. Lynn's recent book ... arises directly from the old antitrust tradition, and it presents us with an amazing catalogue of present-day monopolies, oligopolies and economic combinations. Its subjects are, by definition, some of the largest and most powerful organizations in the world. And yet almost none of it was familiar to me.
Mr. Lynn tells us, for example, about the power of single companies or small groups of companies over such disparate fields as eyeglasses, certain categories of pet food, washer-dryer sales, auto parts, many aspects of food processing, surfboards, medical syringes...
Nor had I ever heard about what Mr. Lynn calls "the vitamin cartel," or the "nearly complete roll-up" of advertising agencies, or that the "key industrial legacy" of now-imprisoned business executive Dennis Kozlowski was a company "that specialized in forging monopolies over U.S. marketplaces for everything from catheters to fire sprinklers to clothes hangers," or that a recent management book encourages readers to see monopoly power as the main goal of business strategy.

Mr. Lynn is a senior fellow at the New America Foundation in Washington; he first came to my attention with a memorable 2006 essay in Harper's Magazine in which he described the power Wal-Mart exerted over its suppliers...

Mr. Lynn ... describes companies that swallow their rivals and then, with competitive pressure diminished, set about "destroying product variety and diversity." ... We learn of entire industries where competitors have grown so close to one another that a collapse at one company would probably bring down many of the others as well.

This is, we are often reminded, a populist age, with fresh flare-ups of fury every time Wall Street bonuses hit the headlines. ...Mr. Lynn's anger at the Wall Street bailout, his fondness for small business, and his frequent homages to the nation's founders may seem superficially similar to the attitudes of the tea party protesters. But Mr. Lynn also takes pains to demonstrate that the economic "freedom" so beloved by the snake-flag set has actually yielded the opposite of freedom: a "neofeudal" system of "private corporate governments" answerable to no one. ...