Economist's View

'Is Finance Too Competitive?'

I don't have any problem at all with the call for more competition in the financial industry, especially measures such as reducing bank size to the minimum efficient scale to reduce their systemic importance and political power. I do have a problem, however, with the idea that competition can substitute for regulation, i.e. that these markets can be left alone to self-regulate:

Is Finance Too Competitive?, by Raghuram Rajan,Commentary, Project Syndicate: Many economists are advocating for regulation that would make banking “boring” and uncompetitive once again. After a crisis, it is not uncommon to hear calls to limit competition. ...

The overwhelming evidence, though, is that financial competition promotes innovation. Much of the innovation in finance in the US and Europe came after it was deregulated in the 1980’s – that is, after it stopped being boring.

The critics of finance, however, believe that innovation has been the problem. Instead of Schumpeter’s “creative destruction,” bankers have engaged in destructive creation in order to gouge customers at every opportunity while shielding themselves behind a veil of complexity from the prying eyes of regulators (and even top management). ... Hence, the critics are calling for limits on competition to discourage innovation.

Of course, the critics are right to argue that not all innovations in finance have been useful, and that some have been downright destructive. By and large, however, innovations such as interest-rate swaps and junk bonds have been immensely beneficial... Even mortgage-backed securities, which were at the center of the financial crisis that erupted in 2008, have important uses... The problem was not with the innovation, but with how it was used – that is, with financiers’ incentives.

And competition does play a role here. Competition makes it harder to make money, and thus depletes the future rents (and stock prices) of the incompetent. In an ordinary industry, incompetent firms (and their employees) would be forced to exit. In the financial sector, the incompetent take on more risk, hoping to hit the jackpot, even while the regulator protects them by deeming them too systemically important to fail.

Instead of abandoning competition and giving banks protected monopolies once again, the public would be better served by making it easier to close banks when they get into trouble. Instead of making banking boring, let us make it a normal industry, susceptible to destruction in the face of creativity.

This seems to imply that breaking banks into smaller pieces makes the system immune to taking on too much risk and the problems that come with it, but we had banking problems in eras where most banks are small -- cascading bank failures in response to a large shock are still possible -- so making markets as competitive as we can, including breaking firms into smaller pieces and allowing easy failure, is no guarantee that financial meltdowns will be avoided (it may, in fact, be harder to step in and save the system when you have to fix many, many small banks instead of a few big ones). I think more competition in this industry is a good idea, but we shouldn't be fooled into thinking that means we can stop worrying about the stability of the system. The focus of the article is innovation, but that is not where the main vulnerability lies. Market failures that allow the equivalent of bank runs on the shadow banking system are a much bigger problem, and this problem cannot be solved by simply reducing firm-size. Regulation to reduce the chances of cascading failure will still be needed.

We Must 'Stand Up to Concentrated and Powerful Corporate Interests'

Simon Johnson:

The Importance of Elizabeth Warren: One of the most important results on Tuesday was the election of Elizabeth Warren as United States senator from Massachusetts. ... Hopefully, Ms. Warren will get a seat on the Senate Banking Committee, where at least one Democratic slot is open.

President Obama should now listen to her advice. ... If President Obama wants to have impact with his second term, he needs to stand up to the too-big-to-fail banks on Wall Street.

The consensus among policy makers has shifted since 2010, becoming much more concerned about the dangers posed by global megabanks. ...

Senator Warren is well placed, not just to play a role in strengthening Congressional oversight but also in terms of helping her colleagues think through what we really need to make our financial system more stable.

We need a new approach to regulation more generally – and not just for banking. We should aim to simplify and to make matters more transparent, exactly along Senator Warren’s general lines.

We should confront excessive market power, irrespective of the form that it takes. We need a new trust-busting moment. And this requires elected officials willing and able to stand up to concentrated and powerful corporate interests. ...

I'm glad to see Simon Johnson at least hinting that this criticism goes beyond just banks. Growing economic power is not limited to the financial sector, and attempts to "stand up to concentrated and powerful corporate interests" must be broadened beyond "too big to fail" financial institutions:

The economics of enormity, The Economist: How big is too big? America's firms are growing in size and while there have been huge firms stretching back to Standard Oil the fact that so many firms are so big is a new phenomenon. This week's Free exchange print article—Land of the corporate giants—takes a look at the implications of the megafirm era. As many of the names towards the top of the list (Exon Mobil, ConocoPhillips) suggest, lots of the growth at the very top is due to mergers. In some cases this is a good thing because bigger firms can be more efficient when they exploit economies of scale. But evidence suggests that scale economies are starting to wear thin. That's a concern given that many mergers are justified on the basis of cost efficiencies (see Waddling forward, also in this week's newspaper, for example). Even more worryingly, other studies suggest that some companies are bulking up for entirely the wrong reasons. Bigger isn’t always better. Read the article here.

Monopoly power distorts both economic activity -- you pay more, and less is produced -- and the distribution of income. And if you are big enough, it also gives you political power and influence. We should do more, much more, to eliminate excessive economic power.

'The Power of Concerted Lobbying'

Mark Roe:

The United States Securities and Exchange Commission (SEC) recently rejected proposed rules aimed at making money-market funds safer in a financial crisis – a rejection that has caused consternation among observers and other regulators. Given the risks that money market funds can pose to the global financial system, as shown by their destabilizing role in the 2008 financial crisis, it is not hard to see why they are worried.

What happened? It won't surprise you:

A majority of the commissioners turned down the proposals after substantial lobbying from the mutual-fund industry. ...

The SEC’s rejection of the proposed rules demonstrates the power of concerted lobbying – and that concentrated interests often trump diffuse benefits. Typically, an interest group lobbies Congress, blandishing persuasive arguments, campaign contributions, and other support; often enough members – or enough key members – come to see the merit of the group’s point of view (or at least vote as if they do). Meanwhile, ordinary citizens do not notice unless the issue receives significant media attention. Often no one lobbies the other side of the issue. ...

With no one having a direct financial interest in the outcome pressing an alternative view, the SEC’s initial decision was as predictable as it was bad.

I'm not sure people appreciate the degree to which the problems that caused the financial meltdown are still present in the fianncial industry (or, if the word "caused" is objectionable, there was certainly a failure to provide the safety relief valves that would have greatly reduced the severity of the problems).

Regulatory Competition, Regulatory Arbitrage, and Regulatory Capture

This is from Rajiv Sethi's review of Sheila Bair's recent book, which he describes as "a crisis narrative and a thoughtful reflection on economic institutions and policy":

... A fragmented regulatory structure with a variety of norms and standards encourages financial institutions to shop for the weakest regulator. In the lead up to the crisis, such regulatory shopping occurred between banks and nonbanks, with mortgage brokers and securities firms operating outside the stronger regulations imposed on insured banks. But Bair also notes that the "three biggest problem institutions among insured banks - Citigroup, Wachovia, and MaMu - had not shopped for charters; they had been with the same regulator for decades. The problem was that their regulators did not have independence from them."

This is the problem of regulatory capture. Bair argues that while a single monolithic regulator would put an end to regulatory arbitrage, it could worsen the problem of regulatory capture: "a diversity of views and the ability of one agency to look over the shoulder of another is a good check against regulators becoming too close to the entities they regulate." It's a point that she has made before, and clearly believes (with considerable justification) that the FDIC has provided such checks and balances in the past. It was able to do so in part through its power under the law and in part through the power to persuade; yet another reminder of the continued relevance of Albert Hirschman's notion of voice. ...

Sheila Bair on the Financial Crisis

From a Marketplace interview of Sheila Bair:

... Jeremy Hobson: Now you don't paint a very pretty picture of the relationship between the various regulators -- in particular, your relationship with the New York Fed, which was at the time headed by Timothy Geithner. What was the issue there with you and Geithner?

Bair: Well, I think Tim and I just had profoundly different ways of viewing the world. He, I think, viewed the large financial institutions as entities that needed to be supported, because he viewed them as central to the functioning economy. And I realized their importance to the economy, but I wanted them to have accountability.

In 2009, when the system was stabled, I wanted to launch programs that would have forced banks to cleanse their balance sheet; to sell off a lot of these bad assets. He was not particularly supportive of that approach. So there was little accountability, and also, I think our economy continues to suffer today because we just never dealt with a bloated, inefficient financial sector. We propped it up the way the Japanese did; we didn't have them take their medicine.

Hobson: Well do you think that looking back, then, that we are going to look back at the crisis and the government's response to the crisis, as a bunch of people acting honorably and selflessly and in the interest of the country; or that we will look back and see a rather pathetic picture of people acting in their own interest, or in the interest of these Wall Street firms?

Bair: I think we will look back and see a regulatory response and a Congressional response that was unwilling to show independence to these large financial institutions and that at the end of the day -- not withstanding the rhetoric -- implemented policies that were highly friendly to these institutions.

I don't think that's nefarious; I think it's a skewed perspective. I think Tim Geithner is an honorable person, and he did what he thought was right. But what he thought was right was saving institutions like Citigroup. He identified saving them with saving the country, and they are two very, very different things. ...

In a tweet, Zachary Goldfarb says:

Sheila Bair: "I don’t think helping home owners was ever a priority for" Geithner and Summers.

And:

Beyond their policy disputes, it's clear Geithner and Bair just hated each other. Much have had an impact on quality of outcome.

To repeat a complaint I've made many times, we had a balance sheet recession. In response, one set of balance sheets -- those of financial institutions -- received plenty of attention and help. Not so for household balance sheets, and that is one of the reasons the recovery remains so lethargic.

Eichengreen: Audit the Fed?

Barry Eichengreen argues that the Republicans’ proposal to audit the Federal Reserve is a bad idea:

Audit the Fed?, by Barry Eichengreen, Commentary, Project Syndicate

He's right.

Shiller: Bubbles without Markets

Robert Shiller argues that reining in markets is not the answer to bubbles:

Bubbles without Markets, by Robert Shiller, Commentary, Project Syndicate: A speculative bubble is a social epidemic whose contagion is mediated by price movements. News of price increase enriches the early investors, creating word-of-mouth stories about their successes... The excitement then lures more and more people into the market ... in successive feedback loops as the bubble grows. After the bubble bursts, the same contagion fuels a precipitous collapse, as falling prices cause more and more people to exit the market, and to magnify negative stories about the economy.

But, before we conclude that we should now, after the crisis, pursue policies to rein in the markets, we need to consider the alternative. In fact, speculative bubbles are just one example of social epidemics, which can be even worse in the absence of financial markets. In a speculative bubble, the contagion is amplified by people’s reaction to price movements, but social epidemics do not need markets or prices to get public attention and spread quickly.

Some examples of social epidemics unsupported by any speculative markets can be found in Charles MacKay’s 1841 best seller Memoirs of Extraordinary Popular Delusions and the Madness of Crowds.The book made some historical bubbles famous: the Mississippi bubble 1719-20, the South Sea Company Bubble 1711-20, and the tulip mania of the 1630’s. But the book contained other, non-market, examples as well.

MacKay gave examples, over the centuries, of social epidemics involving belief in alchemists, prophets of Judgment Day, fortune tellers, astrologers, physicians employing magnets, witch hunters, and crusaders. Some of these epidemics had profound economic consequences. The Crusades from the eleventh to the thirteenth century, for example... Between one and three million people died in the Crusades.

There was no way, of course, for anyone either to invest in or to bet against the success of any of the activities promoted by the social epidemics – no professional opinion or outlet for analysts’ reports on these activities. So there was nothing to stop these social epidemics from attaining ridiculous proportions. ...

The recent and ongoing world financial crisis pales in comparison with these events. And it is important to appreciate why. Modern economies have free markets, along with business analysts with their recommendations, ratings agencies with their classifications of securities, and accountants with their balance sheets and income statements. And then, too, there are auditors, lawyers and regulators.

All of these groups have their respective professional associations, which hold regular meetings and establish certification standards that keep the information up-to-date and the practitioners ethical in their work. The full development of these institutions renders really serious economic catastrophes – the kind that dwarf the 2008 crisis – virtually impossible.

Setting aside the extent to which these are really bubbles as commonly understood, nobody is talking about eliminating markets entirely. The push from those of us who want to "rein in the markets" is to regulate them so they function better than they did prior to the crisis. I don't see how these examples of so called non-market bubbles argue against regulating markets to make them work better. Modern economies may have something like the "free markets" Shiller talks about, but unregulated markets do not always function in the public's best interest and regulations that rein them in and make them more competitive, less subject to catastrophic failure, etc. can improve their social value. The question isn't about markets versus non-markets, the question is how to make our existing insitutions perform better and none of the above helps much with that question. How, for example, can we make business analysts, ratings agencies, accountants, lawyers, and regulators that Shiller lauds -- all of whom fell down on the job to some extent prior to the crisis -- do a better job next time?

Finally, I can't help asking: What is his definition of "really serious catastrophe"? How many millions of unemployed does it take? I'd hate to see a crisis that "dwarfs" this one, but this was no walk in the park. Perhaps the crowd Shiller hangs around in didn't think it was all that serious, but for many, many people it was quite catastrophic.

Update: I should have also added that the fact that this recession, while severe, didn't reach the depths of the Great Depression has more to do with improved social insurance, better automatic stabilizers, better policy (though far from perfect), and a higher initial level of wealth than it does the presence of free markets, business analysts, ratings agencies, accountants, auditors, lawyers, and regulators.

'The Market Has Spoken, and It Is Rigged'

Simon Johnson:

The Market Has Spoken, and It Is Rigged, by Simon Johnson, Commentary, NY Times: In the aftermath of the Barclays rate-fixing scandal, the most surprising reaction has been from people in the financial sector who fully understand the awfulness of what has happened. Rather than seeing this as an issue of law and order, some well-informed people have been drawn toward arguments that excuse or justify the behavior of the Barclays employees.

This is a big mistake.. The behavior at Barclays has all the hallmarks of fraud... Anyone who takes personal responsibility seriously should want all those involved to be held accountable – to the full extent of the law in all jurisdictions. Anything that lets individuals escape consequences will further undermine the legitimacy that underpins all markets. ...

Nevertheless, five arguments put forward in the last 10 days ... attempt to provide some sort of cover for what happened at Barclays. None of these arguments have any merit.

First, it is argued that this kind of cheating around Libor has been going on for a long time. This may be true, but it is a sad and lame excuse... Second, it is also asserted that “everyone does it.” This is not any kind of defense – try it next time you are accused of fraud. ...

Third, Libor-rigging is defended as a “victimless crime.” This is untrue. Traders at Barclays and other banks gained from this series of manipulations, so someone else lost. ...

Fourth, some contend that it is the regulators’ responsibility and fault that there was cheating on Libor. It is certainly the case that there was regulatory capture at work... But who does the capturing in regulatory capture? Big banks work long and hard and lobby at many levels to push regulators toward paying less attention.

Fifth, the weakest argument is, “It was only a few basis points, here and there”... Either the Libor reporting process and, consequently, the pricing of derivatives has been corrupted by a criminal conspiracy, or it has not. There is no “just a little” in this context for the enormous global securities market. ...

How will this play in American politics? There is still time for politicians on the right and on the left of the political spectrum to get ahead of the issue. Digging in around specious arguments in favor of price-fixing cartels is not the way to go.

Power corrupts, and financial market power has completely corrupted financial markets. ...

There's also the argument that regulating the industry will harm economic growth, but look at the growth rates we currently have -- thanks in large part to an out of control financial sector -- to see the folly of that claim. Deregulation of the financial industry did not bring us the robust economy that we were promised, it brought disaster, fraud, and who knows what else, and more oversight is clearly needed.

Bigger is Not Always Better

Robert Reich is pleased to see the Justice Department crackdown on "Big Pharma," but doesn't think think the government is doing anywhere near enough to solve the problem:

How Not to Get Big Pharma to Change Its Ways, by Robert Reich: Earlier this week the Justice Department announced a $3 billion settlement of criminal and civil charges against pharma giant GlaxoSmithKline — the largest pharmaceutical settlement in history — for improper marketing prescription drugs in the late 1990s to the mid-2000s.

The charges are deadly serious. Among other things, Glaxo was charged with promoting to kids under 18 an antidepressant approved only for adults; pushing two other antidepressants for unapproved purposes,... and, to further boost sales of prescription drugs, showering doctors with gifts, consulting contracts, speaking fees, even tickets to sporting events.

$3 billion may sound like a lot of money, but during these years Glaxo made $27.5 billion on these three antidepressants alone,... so the penalty could almost be considered a cost of doing business. 

Besides, to the extent the penalty affects Glaxo’s profits and its share price, the wrong people will be feeling the financial pain. ... Not a single executive has been charged — even though some charges against the company are criminal. ...

The Glaxo case is the latest and biggest in a series of Justice Department prosecutions of Big Pharma for illegal marketing prescription drugs. ... The Department says the prosecutions are well worth the effort. By one estimate it’s recovered more than $15 for every $1 it’s spent.

But what’s the point if the fines are small relative to the profits, if the wrong people are feeling the financial pinch, and if no executive is held accountable? 

The only way to get big companies like these to change their behavior is to make the individuals responsible feel the heat.

An even more basic issue is why the advertising and marketing of prescription drugs is allowed at all, when consumers can’t buy them and shouldn’t be influencing doctor’s decisions anyway. Before 1997, the Food and Drug Administration banned such advertising on TV and radio. That ban should be resurrected.

Finally, there’s no good reason why doctors should be allowed to accept any perks at all from [drug] companies... It’s an inherent conflict of interest. Codes of ethics that are supposed to limit such gifts obviously don’t work. All perks should be banned, and doctors that accept them should be subject to potential loss of their license to practice.  

Simon Johnson, summarizing Dennis Kelleher of the blog Better Markets, says banks have the same problem:

... Global megabanks have an incentive to deceive customers, including both individuals and nonfinancial corporations. Their size confers both market power and the political power needed to conceal the extent to which they engage in economic fraud. The lack of transparency in derivatives markets provides them with an opportunity to cheat, but the abuses are much wider – as the Libor scandal demonstrates. The ripoff is not just of retail investors. ...

This has motivated Samuel Brittan of the Financial Times to rethink his view of competitive markets. Sort of:

As one of the few commentators to have always favored competitive market capitalism I have had to ask myself a few questions. Apart from scandals such as the Libor rate fixing, we have had the behavior of banks before the great recession; a trend to much greater concentration of income and wealth, squeezing the living standards of ordinary citizens; and one could go on.

So, after asking himself these questions, what does he propose?:

Yet if anyone expects me to issue a clarion call for more state ownership and control, they will be disappointed. ... What then has gone wrong? ... Few of us like competition; and the tendency to form closely knit groups to keep outsiders at bay is probably as old as the human race. For pre-capitalist examples one has only to think of the medieval guilds, whether of craftsmen or Master Singers. More subtle are the practices of bankers, as they come disguised as services for customers. In summary, success has depended more on whom you know than what you know. Hence the catchphrase “crony capitalism”. ...

The biggest obstacle to reform is that insiders can devote time and energy to maintaining their position. For ordinary citizens, political reform is a sideshow that hardly repays such efforts. The protests in financial canters are a well-meant but ill-focused attempt to offset this bias.

Yet nil desperandum. The UK corn laws were repealed and the US antitrust acts were passed; and in time both the financiers and the Eurocrats will be brought down.

So, no cause for despair? Not so sure about that (the changes he describes did not come easily). It feels a bit like the Libor scandal has produced a turning point, but the power hold on politicians is still as strong as ever. We've seen how some Democrats react if Obama so much as points a finger in the direction of the financial industry, and if Romney is elected does anyone think the government will get tougher with big banks, big pharma, or big anything else?

Why Zingales Now Endorses Glass-Steagall

Luigi Zingales has changed his mind about Glass-Steagall:

Why I was won over by Glass-Steagall, by Luigi Zingales, Commentary, FT: I have to admit that I was not a big fan of the forced separation between investment banking and commercial banking along the lines of the Glass-Steagall Act in the US. I do not like restrictions to contractual freedom, unless I see a compelling argument that the free market gets it wrong. Nor did I buy the argument that the removal of Glass-Steagall contributed to the 2008 financial crisis. The banks that were at the forefront of the crisis – Bear Stearns, Lehman Brothers, Washington Mutual, Countrywide – were either pure investment banks or pure commercial banks. The ability to merge the two types was crucial in mounting swift rescues to stabilize the system – such as the acquisition of Bear Stearns by JP Morgan and of Merrill Lynch by Bank of America.

Over the last couple of years, however, I have revised my views and I have become convinced of the case for a mandatory separation.

There are certainly better ways to deal with excessive risk-taking behavior by banks, but we must not allow the perfect to become the enemy of the good. In the absence of these better mechanisms, it makes perfect economic sense to restrict commercial banks’ investments in very risky activities, because their deposits are insured. Short of removing that insurance – and I doubt commercial banks are ready for that – restricting the set of activities they undertake is the simplest way to cope with the burden that banks can impose on taxpayers. ...

I was initially swayed by Dean Baker's argument that the banks that caused the most trouble were "either pure investment banks or pure commercial banks" as noted above, and thus that reestablishing a forced separation between the two types of institutions would not do much to insulate us from crises in the future. By my view on this has also evolved along the same lines, e.g. that "With the repeal of Glass-Steagall, investment banks exploded in size and so did their market power" leading to "an opaque over-the-counter market populated by a few powerful dealers," that "The separation between investment and commercial banking also helps make the financial system more resilient," and that, importantly, "Glass-Steagall helped restrain the political power of banks." This should not be the only thing we do to try to make the financial system more stable, there is much,much more that needs to be done. But it is an important part of the effort. (One more note on this -- I also think that there were additional vulnerabilities created by the removal of Glass Steagall. Even if those additional vulnerabilities didn't cause trouble this time around, that doesn't mean they never can. Re-imposing the separation between investment banking and commercial banking eliminates some of these potential problems.)

Paul Krugman: Dimon’s Déjà Vu Debacle

Opponents of regulation end up making a strong case for it:

Dimon’s Déjà Vu Debacle, by Paul Krugman, Commentary, NY Times: Sometimes it’s hard to explain why we need strong financial regulation — especially in an era saturated with pro-business, pro-market propaganda. So we should always be grateful when someone makes the case for regulation more compelling and easier to understand. And this week, that means offering a special shout-out to two men: Jamie Dimon and Mitt Romney. ...

First,... let me talk about Mr. Romney... Here’s what the presumptive Republican presidential nominee said about JPMorgan’s $2 billion loss (which may actually have been $3 billion, or $5 billion, or more, but who’s counting?): “This was a loss to shareholders and owners of JPMorgan and that’s the way America works. Some people experienced a loss in this case because of a bad decision. By the way, there was someone who made a gain.”

What’s wrong with this statement? Well,... it’s not O.K. for banks to take the kinds of risks that are acceptable for individuals, because when banks take on too much risk they put the whole economy in jeopardy — unless they can count on being bailed out. And the prospect of such bailouts ... strengthens the case that banks shouldn’t be allowed to run wild, since they are in effect gambling with taxpayers’ money.

Incidentally, how is it possible that Mr. Romney doesn’t understand all of this? His whole candidacy is based on the claim that his experience at extracting money from troubled businesses means that he’ll know how to run the economy — yet whenever he talks about economic policy, he comes across as completely clueless.

Anyway,... Jamie Dimon ... has ... been ... posing as a responsible banker who knows how to manage risk — and therefore the point man in Wall Street’s fight to block ... regulation... Trust us, Mr. Dimon has in effect been saying, we’ve got this covered and it won’t happen again. Now the truth is coming out..., even as Mr. Dimon was giving speeches about responsible banking, his own institution was heaping on the risk. ...

The point, again, is that an institution like JPMorgan — a too-big-to-fail bank ... whose deposits are already guaranteed by U.S. taxpayers — shouldn’t be engaged in this kind of speculative investment at all. And that’s why we need ... much stronger financial regulation...

Will we get that kind of regulation? Not if Mr. Romney wins... Even if President Obama is re-elected, getting the kind of regulation we need will be an uphill struggle. But as Mr. Dimon’s debacle has just demonstrated, that struggle remains as necessary as ever.

Paul Krugman: Why We Regulate

The financial industry needs better safeguards against excessive, potentially costly risk-taking:

Why We Regulate, by Paul Krugman, Commentary, NY Times: ...Jamie Dimon, the chairman and C.E.O. of JPMorgan Chase,... has ... been fond of giving ... speeches about how he and his colleagues know what they’re doing, and don’t need the government looking over their shoulders. So there’s a large heap of poetic justice — and a major policy lesson — in JPMorgan’s shock announcement that it somehow managed to lose $2 billion in a failed bit of financial wheeling-dealing.

Just to be clear, businessmen ... make money-losing mistakes all the time. That in itself is no reason for the government to get involved. But banks are special, because the risks they take are borne, in large part, by taxpayers and the economy as a whole. ...

So what can be done? In the 1930s, after the mother of all banking panics, we arrived at a workable solution, involving both guarantees and oversight. On one side, the scope for panic was limited via government-backed deposit insurance; on the other, banks were subject to regulations intended to keep them from abusing the privileged status they derived from deposit insurance... Most notably, banks with government-guaranteed deposits weren’t allowed to engage in the often risky speculation characteristic of investment banks like Lehman Brothers.

This system gave us half a century of relative financial stability. Eventually, however, the lessons of history were forgotten. New forms of banking without government guarantees proliferated...

It’s clear, then, that we need to restore the sorts of safeguards that gave us a couple of generations without major banking panics. It’s clear, that is, to everyone except bankers and the politicians they bankroll... Did I mention that Wall Street is giving vast sums to Mitt Romney, who has promised to repeal recent financial reforms?

Enter Mr. Dimon. JPMorgan ... managed to avoid many of the bad investments that brought other banks to their knees. This apparent demonstration of prudence has made Mr. Dimon the point man in Wall Street’s fight to delay, water down and/or repeal financial reform. ... Just trust us, the JPMorgan chief has in effect been saying; everything’s under control.

Apparently not. ...

For the moment Mr. Dimon seems chastened, even admitting that maybe the proponents of stronger regulation have a point. It probably won’t last; I expect Wall Street to be back to its usual arrogance within weeks if not days.

But the truth is that we’ve just seen an object demonstration of why Wall Street does, in fact, need to be regulated. Thank you, Mr. Dimon.

The Slippery Slope for Health Care's Slippery Slope Opposition

Richard Thaler:

Slippery-Slope Logic, Applied to Health Care, by Richard Thaler, Commentary, NY Times: There are lots of important things to worry about these day... So it is important that we limit our worries to real as opposed to imaginary risks.

One pernicious category of imaginary risks involves ... dreaded “slippery slope” arguments. Such arguments are dangerous because they are popular, versatile and often convincing, yet completely fallacious. Worse, they are creeping into ... the Supreme Court ... deliberations on health care reform.

There is a DirecTV ad that humorously illustrates the basic form of the slippery-slope argument. A foreboding announcer intones a list of syllogisms that are enacted on screen: “When your cable company puts you on hold, you get angry. When you get angry, you go blow off steam. When you go blow off steam, accidents happen.” Later, we reach the finale: “You wake up in a roadside ditch. Don’t wake up in a roadside ditch.” ... The idea is that while Policy X may be acceptable, it will inevitably lead to the terrible Outcome Y... The problem is that such arguments are often made without any evidence that doing X makes Y more likely, much less inevitable. ...

Given how flimsy slippery-slope arguments can be, it is downright scary that they might play an important role in the Supreme Court decision on ... whether it is constitutional for the federal government to penalize people who fail to buy health insurance. ...

Consider these now-famous comments about broccoli from Justice Antonin G. Scalia during the oral arguments. “Everybody has to buy food sooner or later, so you define the market as food,” he said. “Therefore, everybody is in the market. Therefore, you can make people buy broccoli.” Showing remarkable restraint, he did not mention anything about ending up in a roadside ditch. ...

Please stop! The very fact that a slippery slope is being cited as grounds for declaring the law unconstitutional ... tells you all that you need to know about the argument’s validity. Can anyone imagine Congress passing a broccoli mandate law, much less the court allowing it to take effect? ... Surely, the justices have the conceptual resources to draw a distinction between the health care market and the market for broccoli. And even if they don’t, then all the briefs, the zillions of blog posts and a generation’s worth of economic literature can help them.

More generally, we would be better off as a society if we could collectively agree to ignore all slippery-slope arguments that aren’t accompanied by evidence that said slope exists. ...

"Too Big To Manage"

Yesterday, Tim Duy reacted to the troubles at JP Morgan Chase with "Too Big To Fail Lives On." Simon Johnson agrees, and says it's time to change the rules:

JP Morgan Debacle Reveals Fatal Flaw In Federal Reserve Thinking, y Simon Johnson: Experienced Wall Street executives and traders ... always insist that attempts to re-regulate Wall Street are misguided because risk-management has become more sophisticated – everyone, in this view, has become more like Jamie Dimon, head of JP Morgan Chase, with his legendary attention to detail and concern about quantifying the downside.

In the light of JP Morgan’s stunning losses on derivatives, announced yesterday but with the full scope of total potential losses still not yet clear (and not yet determined), Jamie Dimon and his company do not look like any kind of appealing role model. But the real losers in this turn of events are the Board of Governors of the Federal Reserve System and the New York Fed, whose approach to bank capital is now demonstrated to be deeply flawed.

JP Morgan claimed to have great risk management systems – and these are widely regarded as the best on Wall Street. But what does the “best on Wall Street” mean when bank executives and key employees have an incentive to make and misrepresent big bets – they are compensated based on return on equity, unadjusted for risk? Bank executives get the upside and the downside falls on everyone else – this is what it means to be “too big to fail” in modern America.

The Federal Reserve knows this, of course – it is stuffed full of smart people. ... To prevent this..., the Fed now runs regular “stress tests” to assess how much banks could lose – and therefore how much of a buffer they need in the form of shareholder equity. In the spring, JP Morgan passed the latest Fed stress tests with flying colors. ...

The lessons from JP Morgan’s losses are simple. Such banks have become too large and complex for management to control what is going on. ... And the regulators also have no idea about what is going on. Attempts to oversee these banks in a sophisticated and nuanced way are not working....

Anat Admati and her colleagues at Stanford (and her growing band of supporters in the US and around the world) are right about bank capital. The people in charge of Federal Reserve policy in this regard are dead wrong...

Ms. Admati skewered Jamie Dimon at length and in detail 18 months ago on exactly these issues. You must read her original Huffington Post piece. She has been relentless ever since – see this material. She was right then and she is right now: we need much higher capital requirements and much simpler rules – focus on limiting leverage. Big banks should be forced to become smaller – small enough and simple enough to fail.

It is time for the Federal Reserve to move its policy on these issues.

Strike when the Iron is Hot

Just a quick note. As you've probably figured out, I am at the Milken Global Conference and it's interesting how much financial reform has faded from the agenda. Two years ago, many, many sessions were devoted to how the financial sector would need to be reformed. Financial executives and others who spoke in the sessions admitted they had screwed up, and it seemed like many people, even those on the right of the political spectrum, agreed on the need for change. There were many warnings about doing this correctly, and disagreement about what "correct" means, but there was a general acknowledgment change of some sort was coming (and needed).

Last year, reform was still on the agenda, though not as much, and this year it has faded even more (there is one session devoted to global financial regulation). The main concern now is how to get the economy back to where it was before all this trouble hit. Part of that is an effort to roll back the little change we did manage to put into place in the financial sector, a theme that has emerged generally among the speakers who are politically conservative. For example, though it wasn't pointed directly at financial reform, I heard in a session yesterday that if government would just get out of the way we'd be back to full employment already.

It reminds me of the apologies that come after bad behavior. The next day, the person is apologetic, promises to change, etc., etc., and you hope they are serious this time. But over time, you realize the apologies were hollow --very little actually changes -- and it's only a matter of time until it happens again.

When financial reform first came up, there was a debate about whether to do it fast while the momentum and will for reform were there even if it might be a bit rushed and imperfect versus taking more time to get it right and risking that people would forget why reform is needed. Watching the process now, I think those who wanted to do it fast (and then fix any problems later) had the better argument. Waiting in an attempt to get it right doesn't work. We won't get any new meaningful regulation at this point, event though it's still needed, and we'll be lucky to keep what we have.

The Clean Water Act Worked

Pollution levels off the California coast have dropped significantly since the passage of the Clean Water Act (i.e., contra Repulicans, government is not always the problem):

First evaluation of the Clean Water Act's effects on coastal waters reveals major successes, EurekAlert: Landmark legislation helped clean up LA's coastal waters over the past 40 years, study indicates

Levels of copper, cadmium, lead and other metals in Southern California's coastal waters have plummeted over the past four decades, according to new research from USC.

Samples taken off the coast reveal that the waters have seen a 100-fold decrease in lead and a 400-fold decrease in copper and cadmium. Concentrations of metals in the surface waters off Los Angeles are now comparable to levels found in surface waters along a remote stretch of Mexico's Baja Peninsula.

Sergio Sañudo-Wilhelmy, who led the research team, attributed the cleaner water to sewage treatment regulations that were part of the Clean Water Act of 1972 and to the phase-out of leaded gasoline in the 1970s and 1980s. ...

60 Minutes: The Case Against Lehman Brothers

Via Barry Ritholtz, who says "Other than getting Lehman’s role in the overall crisis wrong, this is a fascinating look at Lehman’s demise":

[transcript]

Republicans Want to Repeal Resolution Authority

This is crazy:

the House Republicans on the Financial Services Committee just voted to repeal "resolution authority."

Let's review the history. When the crisis hit, the government bailed out many financial firms -- shadow banks as they are known. That's not what it does when an ordinary bank fails. When ordinary banks fail, the government takes over the bank, puts the good assets in one pile, the bad assets in another, then repackages the good assets into a new bank that is sold back to the private sector as soon as possible.

This has many advantages, including the ability to replace managers of failed firms instead of rewarding them with a bailout. So why wasn't this approach adopted during the financial crisis? The Treasury argues that it did not have the legal authority to take over large shadow banks -- these banks fell outside of the existing regulatory umbrella (there is dispute on this point, some people claim the government regulators could have twisted existing regulation to allow this, but government regulators insist otherwise). Thus, government regulators believed there were only two (bad) choices. Let too big to fail banks fail and suffer the economic consequences, or to bail them out, including bailing out the owners and managers who had led the banks to disaster. If it had resolution authority -- the ability to step in take over when banks fail -- the rewards to management could have been avoided, and taxpayers could have been better protected in other ways, but limits on legal authority gave regulators only two bad options. Do nothing, or bail the banks out.

The resolution authority in Dodd-Frank is intended to fix this problem by putting into place a procedure that is similar to what is done with ordinary banks. Resolution authority allows government regulators to take control of the banks, fix the problems, and then return them to the private sector. But, and this is important to recognize, Dodd-Frank also prevents the type of bank bailout that was done during the financial crisis.

Thus, the authority for the type of bailout that we saw during the crisis no longer exists. If if we now remove resolution authority there will be just one choice if a too big to fail firm gets in trouble -- let it fail. That, and the cascading shadow bank failures that would follow, would be a disaster.

I was unsure that resolution authority as spelled out in Dodd-Frank would actually work. If a large, systemically important bank was failing, would regulators have the courage to try this risky new procedure, or would they fall back on what has worked before, the type of bailouts we saw during the crisis? The legal authority to do bailouts is now gone, so a bailout is no longer a choice, but the law could always be altered quickly and I expected that might happen when the next financial crisis hits.

But we need to be able to do one or the other -- to bail them out or put them through resolution authority -- and resolution authority would be much better if it works. The idea embraced by Republicans that letting these banks fail will prevent moral hazard (banks will take less risks if they know there's no bailout coming, or if the managers will get kicked out as resolution authority is exercised), but won't cause a disaster, is nuts. Financial history tells us that failing to step in and do something -- a bailout or resolution authority -- leads to cascading bank failures and economic disaster. Saying government won't step in to save a system in cascading failure is not a credible threat. It will step in. So this doesn't fix the moral hazard the GOP is so worried about, and it likely makes it worse since the moral hazard associated with a bailout is larger than with resolution authority. I am not sure that resolution authority will work, we may still need to do a bailout anyway, but letting large, systemically important banks fail as the GOP would have us do is not a risk we ought to take.

Shiller: Democratize Wall Street, for Social Good

Robert Shiller is bullish on Wall Street:

Democratize Wall Street, for Social Good, byRobert Shiller, Commentary, NY Times: Many finance students and members of the Occupy Wall Street movement have a great deal in common: a deep interest in democratizing Wall Street.

At Yale, where I have been teaching for 25 years, I’ve been hearing a great deal lately from my students about financial innovations linked to social media. One such innovation, called crowdfunding, is embedded in the jobs bill signed into law by President Obama... The idea involves Web sites that help many investors contribute small amounts of capital to projects that they read about online, and that might otherwise be starved for money. ... There may well be disappointments at first, but the concept can be tinkered with, like other democratizing financial innovations that have eventually delivered much good to society. ...

Financial innovation, of course, takes unanticipated forms, but wherever it turns next, we can expect some breathtaking transformations during the careers of today’s students. And despite the damage to its reputation from the subprime mortgage crisis and its aftermath, financial innovation could help solve many vexing problems...

Contrary to popular opinion these days, the history of finance marks ... “ever-widening circles of activity” with products ranging from venture capital to home mortgages to various forms of insurance, savings and pensions. The faults in institutions that contributed to the recent financial crisis can be corrected... The challenge ahead — both for my students bound for the world of finance and for those who would occupy it — is to truly democratize Wall Street.

This financial innovation stuff is apparently pretty magical. It can "help reduce social inequality ..., deal with the problem of rigid entitlements ..., make our responses to catastrophes more intelligent, ... channel our gambling impulses into something more constructive, ... better direct creative energies," and "focus specifically on problems specific to the very poor." And to top it off, "It can make speculative bubbles less of a problem, and help make prices in financial markets better reflect fundamental information."

Is there anything that financial innovation can't do to make the world a better place?

More seriously, sure, financial innovation has had its successes, but some of it just redistributes income -- in both intentional and unintentional ways -- without much to show in terms of efficiency, and there have been catastrophic breakdowns as well with costs that spread far and wide. No news there given what we've just been through. So I suppose I'm not so positive about Wall Street -- too many China shops are still under repair from the last time bullish financial  innovation got loose -- and would prefer to see more emphasis on how to keep the system stable in the future.

Paul Krugman: Broccoli and Bad Faith

The Supreme Court is undermining the public's confidence in its ability to stand above politics:

Broccoli and Bad Faith, by Paul Krugman, Commentary, NY Times: Nobody knows what the Supreme Court will decide with regard to the Affordable Care Act. But ... it seems quite possible that the court will strike down the “mandate” — the requirement that individuals purchase health insurance — and maybe the whole law. Removing the mandate would make the law much less workable, while striking down the whole thing would mean denying health coverage to 30 million or more Americans.

Given the stakes, one might have expected all the court’s members to be very careful... In reality, however,... antireform justices appeared to embrace any argument, no matter how flimsy, that they could use to kill reform.

Let’s start with the already famous exchange in which Justice Antonin Scalia compared the purchase of health insurance to the purchase of broccoli... That comparison horrified health care experts ... because health insurance is nothing like broccoli.

Why? When people choose not to buy broccoli, they don’t make broccoli unavailable to those who want it. But when people don’t buy health insurance until they get sick — which is what happens in the absence of a mandate — the resulting worsening of the risk pool makes insurance more expensive, and often unaffordable, for those who remain. As a result, unregulated health insurance basically doesn’t work, and never has.

There are at least two ways to address this reality... One is to tax everyone ... and use the money raised to provide health coverage. That’s what Medicare and Medicaid do. The other is to require that everyone buy insurance, while aiding those for whom this is a financial hardship.

Are these fundamentally different approaches? ... Here’s what Charles Fried — who was Ronald Reagan’s solicitor general — said..: “I’ve never understood why regulating by making people go buy something is somehow more intrusive than regulating by making them pay taxes and then giving it to them.” ... (By the way, another pet conservative project — private accounts to replace Social Security — relies on, yes, mandatory contributions from individuals.)

So has there been a real change in legal thinking here? Mr. Fried thinks that it’s just politics — and other discussions in the hearings strongly support that perception. ...

As I said, we don’t know how this will go. But it’s hard not to feel a sense of foreboding — and to worry that the nation’s already badly damaged faith in the Supreme Court’s ability to stand above politics is about to take another severe hit.

"Markets or Shareholders?"

Where do crony capitalists get their training?:

Markets or shareholders?, by Niraj Dawar, INSEAD: There is a fine line between professing free-market capitalism and teaching the subversion of those markets that is crossed in business-school classrooms every day. ...

We like to believe in the ideal of free markets because competition, we are convinced, is good for the economy. Competition forces sellers to keep the interests of the buyers at the heart of what they do; competition marginalizes and eliminates inefficient players; and competition for customers and resources spurs innovation... In short, these ideal markets lead to an efficient allocation of the economy’s resources, making us all better off in the long term.

If there is one principle that informs business school curricula, it is the belief in the efficiency and inherent goodness of free markets.

But there is another principle that contends for the title, and that is the belief that the goal of a business organization is the maximization of shareholder value. ... This is a worthy goal... Businesses that aim to maximize shareholder value in competitive markets will use the economy’s resources efficiently.

In a real economy – one that is not your textbook picture-perfect market – the maximization of shareholder value is most efficiently achieved by exploiting market imperfections..., companies get into the business of creating and maintaining regulatory wrinkles so that they can continue to exploit them... Firms that push for government protection in the form of trade barriers, longer patent life, or more global application of patents are attempting to keep competitors out. This type of lobbying for protection and favorable regulation undermines markets in many industries in many countries, including telecoms, banking, airlines, energy, infrastructure, pharmaceuticals, etc. ...

And business schools often end up supporting the erection of regulatory barriers to entry. In other words, at the same time as we profess a reverence for the markets, we’re teaching the subversion of freer markets. ...

Restoring society’s eroding faith in capitalism is not something that will happen overnight. Alleviating popular skepticism of business schools and their graduates may take even longer. But a good place for business schools to start is with some soul searching about where their allegiance resides: with efficient markets in the service of society, or with the creation of market inefficiencies in the service of oligopolies?

(Amusing as it may be to watch, the theater of having MBAs take oaths and participate in ring ceremonies is not going to restore society’s faith in business schools).

This problem won't be solved from within, i.e. by hoping that businesses will suddenly drop behaviors that lead to increased profits. It's the institutions surrounding markets that must adjust.

"A Colossal Mistake"

Simon Johnson says we are "on a bipartisan route to disaster":

A Colossal Mistake of Historic Proportions: The “JOBS” bill, by Simon Johnson: From the 1970s until recently, Congress allowed and encouraged a great deal of financial market deregulation – allowing big banks to become larger, to expand their scope, and to take on more risks. This legislative agenda was largely bipartisan, up to and including the effective repeal of the Glass-Steagall Act at the end of the 1990s. After due legislative consideration, the way was cleared for megabanks to combine commercial and investment banking on a complex global scale. The scene was set for the 2008 financial crisis – and the awful recession from which we are only now beginning to emerge.

With the so-called JOBS bill, on which the Senate is due to vote Tuesday, Congress is about to make the same kind of mistake again – this time abandoning much of the 1930s-era securities legislation that both served investors well and helped make the US one of the best places in the world to raise capital. We find ourselves again on a bipartisan route to disaster.

The Senate needs to slow down and do its job... To pass this legislation on Tuesday would be a grave mistake.

The idea behind the JOBS bill is that our existing securities laws – requiring a great deal of disclosure – are significantly holding back the economy.

The bill, HR3606, received bipartisan support in the House (only 23 Democrats voted against). The bill’s title is JumpStart Our Business Startup Act, a clever slogan – but also a complete misrepresentation. ...

Federal Rulemaking During This Administration

Eric Zorn at the Chicago Tribune tries to set the record straight:

Contrary to a widespread misconception, and in part as a result of close attention to empirical evidence, there has been a decrease, not an increase, in federal rulemaking during this administration. During the first three years of the Obama administration, the number of final rules reviewed by OIRA and issued by executive agencies was actually lower than during the first three years of the Bush administration... Cass Sunstein, administrator of the federal Office of Information and Regulatory Affairs.

Problem is, the actual record doesn't matter (more). The strange thing is that the mythical Obama created by conservatives -- the one who spent more than conservatives, imposed more regulation, protected civil liberties, won't budge on entitlements, etc. -- is probably more attractive to liberal voters than the real deal. But I guess that's not their target audience.

"When Populism Is Sound"

Simon Johnson says there's good populism and bad populism, and we could use a bit of the good populism that has worked so well in the past:

When Populism Is Sound, by Simon Johnson, Commentary, NY Times: “Populism” is a loaded term in modern American politics. On the one hand, it conveys the idea that someone represents (or claims to represent) the broad mass of society against a privileged elite. This is a theme that plays well on the right as well as the left – although they sometimes have different ideas about who is in that troublesome “elite.”

At the same time, populism is often used in a pejorative way – as a putdown, implying “the people” want irresponsible things that would undermine the fabric of society or the smooth functioning of the economy.

In Latin America, for example, there is a long tradition of populists’ falling into bed with a corrupt political elite...

In North America, however, the populist tradition has proved much more constructive. More than 100 years ago, hot-button issues included direct election of senators and a federal income tax. None of these demands seem irresponsible today, and achieving those goals through constitutional amendments in the period before 1914 in no way jeopardized American prosperity....

In their new book, “Why Nations Fail: The Origins of Power, Prosperity and Poverty,” Daron Acemoglu and James Robinson suggest that most economic and political collapse is caused by overly powerful elites — which bring on a wide variety of pathologies....

Important parts of our financial elite, particularly the people who ran large financial institutions, went out of control in the period leading up to 2008. Powerful bankers wreaked havoc with our economy, destroyed millions of jobs and directly caused a huge increase in the national debt. These people and their successors are now poised to get out of control again. ...

Dean Baker adds:

Simon Johnson had a nice blogpost in the NYT arguing that populism has often been a source of good economic ideas in U.S. history with a focus on populist sentiment for breaking up too big to fail banks. At one point Johnson notes some of the constructive measures pushed by populists, noting that the direct election of senators and the income tax were both populist ideas.

One other item that should be on this list is ending the gold standard. This was a rallying cry for the populists throughout their history. It was also good policy, as going off the gold standard laid the basis for the recovery from the Great Depression. 

 

Nordhaus: Why the Global Warming Skeptics Are Wrong

William Nordhaus takes on the climate skeptics:

...I have identified six key issues..., and I provide commentary about their substance and accuracy. They are:

• Is the planet in fact warming?
• Are human influences an important contributor to warming?
• Is carbon dioxide a pollutant?
• Are we seeing a regime of fear for skeptical climate scientists?
• Are the views of mainstream climate scientists driven primarily by the desire for financial gain?
• Is it true that more carbon dioxide and additional warming will be beneficial?

As I will indicate below, on each of these questions, the sixteen scientists provide incorrect or misleading answers. ,,,. I will describe their mistakes and explain the findings of current climate science and economics.

1. The first claim is that the planet is not warming. More precisely, “Perhaps the most inconvenient fact is the lack of global warming for well over 10 years now.”

It is easy to get lost in the tiniest details here. Most people will benefit from stepping back and looking at the record of actual temperature measurements. The figure below shows data from 1880 to 2011 on global mean temperature averaged from three different sources.2 We do not need any complicated statistical analysis to see that temperatures are rising, and furthermore that they are higher in the last decade than they were in earlier decades.3

One of the reasons that drawing conclusions on temperature trends is tricky is that the historical temperature series is highly volatile, as can be seen in the figure. The presence of short-term volatility requires looking at long-term trends. ...

The finding that global temperatures are rising over the last century-plus is one of the most robust findings of climate science and statistics. ...[continue reading]...

Oh No! "This Will Force Banks to Change"!

Surprise, surprise, Larry Tabb, the founder and chief executive of Tabb Group, is complaining about regulation of the financial sector. He starts off strong:

Mea Culpa? Yes, the banks did wrong. They became overlevered; hopped-up on greed, they took on more credit than a loan shark would have extended. When the bets turned sour, they went cap in hand to the taxpayer. Once bailed out, the banks threw petrol on the fire by not being contrite, hoovering up cheap cash, paying bonuses as if there were no tomorrow and refusing to develop a set of even the least offensive business restrictions.

But quickly changes course:

So what did legislators and regulators do? They did what they normally do in a crisis: they legislated and regulated. While the new rules may or may not preclude another crisis, they will certainly punish the banks and may inadvertently punish the taxpayer.

Why, as he notes elsewhere, it's a literal "legislative tsunami"! "This will force banks to change"! We will "inadvertently punish the taxpayer" and "we’ll all be affected"!

You know the jobs argument is coming. Ah, here it is:

As borrowing costs increase, governments, corporations and people will pay more to borrow, reducing investments, leverage, purchases and subsequently jobs.

I think that it's his job, or rather his compensation, that he's really worried about. But you knew that.

Anyway, here's the big ending:

Our challenge as an industry and as a global community will be to understand this new world and ensure that the few mega banks we love to hate don’t get dissolved into thousands of entities we truly despise.

The big banks are bad, but if we break them up it will be even worse, we'll have "thousands of entities we truly despise." So best to leave well enough (ahem) alone.

I'm sure the "founder and chief executive" types making these arguments actually believe they are so very, very important that any attempt whatsoever to regulate their behavior will cost the rest of us big time, but that doesn't mean we have to believe it too.

"Will Wall Street Ever Face Justice?"

The chairman of the Financial Crisis Inquiry Commission, Phil Angelides, wonders if there will ever be a thorough investigation and prosecution of "the financial assault on our country":

Will Wall Street Ever Face Justice?, by Phil Angelides, Commentary, NY Times: Last week, Attorney General Eric H. Holder Jr. proclaimed in a speech that when it comes to fighting financial fraud, the Obama administration’s “record of success has been nothing less than historic.” Such self-congratulation is not only premature, but it also reveals a troubling lack of understanding about what is required to win the war against financial wrongdoing.

Four years after the disintegration of the financial system, Americans have, rightfully, a gnawing feeling that justice has not been served. Claims of financial fraud against companies like Citigroup and Bank of America have been settled for pennies on the dollar, with no admission of wrongdoing. Executives who ran companies that made, packaged and sold trillions of dollars in toxic mortgages and mortgage-backed securities remain largely unscathed.

Meager resources have been applied to investigate the financial assault on our country, which wiped away trillions of dollars in household wealth and has resulted in 24 million people jobless or underemployed. The Financial Crisis Inquiry Commission ... was given a budget of $9.8 million — roughly one-seventh of the budget of Oliver Stone’s “Wall Street: Money Never Sleeps.” The Senate Permanent Subcommittee on Investigations did its work on the financial crisis with only a dozen or so Congressional staff members.

Despite their limited budgets, both inquiries turned over rocks and exposed disturbing financial practices, and both entities referred potential violations of law to the Justice Department. The final reports from the two investigations were completed last year, but the resources that were needed to dig deep beneath those rocks — or the rocks turned over by private litigants or other investigatory efforts — weren’t mobilized. ...

The belated creation of a Residential Mortgage-Backed Securities Working Group, led by federal officials along with New York State’s aggressive attorney general, Eric T. Schneiderman, offers hope that the needed surge of investigation and enforcement may finally be initiated. But for it to succeed, the Obama administration must give the group the wherewithal to do so. ...

No one should seek or condone prosecutions for revenge or political purposes. But laws need to be enforced to deter future malfeasance. Just as important, the American people need to believe that a thorough investigation has been conducted; that our judicial system has been fair to all, regardless of wealth and power; and that wrongs have been righted.

In addition to the need to make those who chose to violate the rules face the consequences of their decisions, a thorough investigation would also help regulators understand where the breakdowns occurred, and thus provide insight into how to better protect the financial system from a repeat performance. Unfortunately, I don't think that there will ever be the kind of investigation that is needed.

"NY Fed to Take More Direct Role in Repo Market"

I've complained many times that the risk of non-traditional bank runs in the repo market, a key factor in the financial crisis, is still present. As noted below in a quote from the NY Fed, the "systemic risk associated with this market remains unchanged." So it's good to see that the NY Fed is finally stepping in with oversight of this market after it waited for the industry to fix itself, and that didn't happen. But why did anyone think the industry would fix itself in the first place?:

New York Fed to Take More Direct Role in Repo Market, by Michael S. Derby, Real Time Economics: The bond market’s inability to reform the market where Wall Street goes to borrow and lend fixed-income securities is leading to more direct involvement from the Federal Reserve Bank of New York.

At issue is the state of the triparty repo market. This sector is the backbone of bond trading... And because the market is dominated by short-term activity, a loss of confidence in a particular firm can kill its access to credit and potentially kill the institution, which can, in turn, create problems for the broader functioning of financial markets.

The effort to repair the market came to a head Wednesday with the release of a report by the Tri-Party Repo Infrastructure Reform Task Force, a private industry group operating with the support of the New York Fed. The report was to offer the group’s final recommendations, but that was evidently more than participants could manage.

Although the task force has made recommendations to improve trading in the repo market, the implementation of them “will require more time and technical implementation than the Task Force originally estimated and will constitute a multiyear project,” the report said. ...

In a related release, the New York Fed was clearly disappointed by the lack of traction the industry’s effort at self-reform had achieved.

“Despite these accomplishments, the amount of intraday credit provided by clearing banks has not yet been meaningfully reduced, and therefore, the systemic risk associated with this market remains unchanged,” the New York Fed said in a statement.

As a result, the bank said it “will intensify its direct oversight” of the triparty repo market. ...

Oversight is one thing, taking action is another, so we'll see what the NY Fed actually does. But at least there's finally some chance of movement on this front.

"Alexander Field, Greg Clark, and Optimism about the Current Unpleasantness"

Why aren't we doing more to rebuild our infrastructure at a time when our needs are high and borrowing costs, labor costs, and other costs of infrastructure are at bargain prices? Not to mention the employment benefits that would come with enhanced infrastructure investment. And why aren't we doing more to shore up our financial infrastructure through new regulations and oversight of the banking sector so that the problems we are having presently are less likely to reappear? There have been some changes in financial regulation, but not enough, and the financial sector is doing its best to block any further progress in this area:

Alexander Field, Greg Clark, and Optimism about the Current Unpleasantness, by Eric Rauchway: On the jacket of Alexander Field’s new book A Great Leap Forward, my colleague Greg Clark says this:

As we sit mired in the Great Recession, Alexander Field’s exciting reappraisal of the Great Depression offers surprising solace. By showing the Great Depression was coupled with the most rapid technological advance in U.S. history, he fundamentally recasts the history of the 1930s. But he also offers hope that our own depression likely will have no long-run costs to the U.S. economy.

By measuring total factor productivity (TFP), or the improvement in productivity not accounted for by traditional inputs, Field finds tremendous gains during the Depression. They owe in part to private investment in manufacturing efficiencies, chemical processes, and other technical improvements. Historiographically, there’s a major payoff in showing that the vast majority of such innovation came during the Depression, not during the war.

But (as the bulk of Field’s book is devoted to showing) the productivity improvement owes mostly to construction transportation infrastructure – to the construction of roads, bridges, and all that made the modern trucking industry possible. Field even goes so far as to say the end of the golden age of productivity in the American economy in 1973 “coincides with [he does not quite say owes to] a tapering off of gains from a one-time reconfiguration of the surface freight system in the United States”.

And this massive public investment in infrastructure, which made possible the postwar suburbanization and boom, went along with financial regulation. Field attributes both the current crisis and that of the 1920s to “a failure to control, or really to be interested in controlling, the growth of leverage.” If we want to come out of the Current Unpleasantness with less than a Great Depression to show for it, we’ll have to see regulation that responds accordingly, he says. “If an even more serious crisis occurs within the next decade, it will be because the regulatory response ended up being less effective than that which was summoned during the New Deal.”

Which makes Field sound a lot less optimistic than Greg. The Great Depression turned out relatively well in the long run because we had not only significant private investment in R&D and other improvements, but also the New Deal – road-building and regulation. Do we have that, or anything like it, now?

"Break Up the Banks? Here’s an Alternative"

Tyler Cowen says there's no need to break up big banks or impose lots and lots of regulations to ensure they can't take excessive risks with other people's money, making shareholders responsible for bank losses would fix the problems:

Break Up the Banks? Here’s an Alternative, by Tyler Cowen, Commentary, NY Times: Bailing out financial institutions deemed “too big to fail” has become wildly unpopular, as people across the political spectrum are now talking about splitting up America’s large banks. But such breakups are probably not the best way forward, because they would penalize size instead of failure. ...

So the logic of cutting down huge institutions could mean splitting the largest ones into several pieces. Yet banks do not always come in easily divisible parts. Such a move could amount to eradicating the largest banks rather than splitting them up — and eradication is both politically unlikely and potentially disastrous for the economy. In short, if the resulting parts of a divided bank cannot turn a profit, the split-up may prompt the very bailout it was trying to avoid.

Another fear is that American money market operations would move to larger foreign banks, which would have a newly found competitive advantage. ...

There is still another problem. The more a bank is legally limited in terms of easily measurable size, the more it may resort to off-balance-sheet activities to make up the difference. “Breaking up big banks” may really mean making these less-transparent bank activities much more important to a bank’s fate.

Maybe tough new rules for off-balance-sheet activities could limit this problem, but the overall history of financial regulation belies that view. ...

There is a better alternative: expanding the liability for major financial institutions. If a shareholder invests a dollar in a big bank, why not make that shareholder liable for the first $1.50 — or more — of losses as insolvency approaches? In essence, we would be making the shareholders liable for the costs that bank failures impose on society, and making the banks sort out the right mixes of activities and risks. ...

This proposal would shrink the financial sector, while avoiding excess regulatory micromanagement of bank activities. But it could still be combined with other regulations, like limits on leverage, if deemed appropriate or necessary.

Unlike the “big is bad” view, this proposal would penalize failing banks rather than safe, successful ones that happen to be large. ...

We need to resist vengeful or “feel good” options for financial reform and embrace those that will really work.

Some notes: First, there's an implicit assumption in this article about the minimum efficient scale for a bank. Tyler worries that breaking up banks will result in less efficient banking operations (i.e. higher cost) causing the smaller banks to fail altogether, or be less competitive with foreign banks.

However, I have not seen convincing evidence that banks need to be as large as they are for efficiency reasons (here's some evidence, but as I noted, I am not convinced by it). I am not advocating a per se rule here -- we shouldn't break them up just because. But if there's evidence that the size leads to undue political or economic power that is being exploited in the banks' favor, and if mega-mega-size is not necessary for efficiency, then there is definitely a reason to break them into smaller pieces. From my perspective, there is quite a bit of evidence that these banks have far too much political influence, and I think a case can also be made that it's unhealthy for the economy to have firms with such a large market share in particular segments of financial markets.

So I think that, absent of strong evidence that there actually are economic efficiencies associated with size (in which case they ought to be treated more like a regulated monopoly than a competitive marketplace), and the evidence that these banks are highly influential politically -- to the point where regulatory capture is more than a passing worry -- we should break these banks into pieces that are closer to the "minimum efficient scale" for financial institutions. I think the minimum is much smaller than current size, but once again, if that's not true then we need to treat these banks more natural monopolies (or natural bilateral monopolies, trilateral monopolies, or too small of a number to be competitive industries).

But we shouldn't fool ourselves into thinking that breaking up big banks into smaller pieces will necessarily make the financial system more stable. We had bank runs and financial meltdowns in eras where there were predominately small banks, think of the Great Depression for example. That's because it's the interconnectedness of banks that causes the problems, and smaller banks can be just as interconnected and hence just as vulnerable to a systemic shock as large banks. Perhaps there's a bit more diversification in larger banks that offers some protection, but the evidence is not strong on this point and big banks appear to be just as vulnerable as small banks to systemic troubles (and vice versa).

The stability of the system has more to do with regulatory restrictions, e.g. controlling the risks that shadow banks can take, or with economic mechanisms of the type Tyler is calling for that get the incentives for financial firms to take risk correct, than it does the size of institutions. I am not as confident as Tyler is that his scheme will work -- I am more inclined to pursue the regulatory route -- but in any case the problem of how to enhance the stability of the financial system is not about the size of banks as much as it's about interconnectedness and the degree to which financial firms can take risks without facing the full consequences of their decisions.

One final note: It seems to me that given the lack of transparency in the financial system -- the inability of investors to monitor the risks that banks are taking with the money they invest, and the lack of solutions such as reliable ratings agencies that help to overcome this informational disadvantage -- making investors liable for even more than they actually invest in a bank would kill the incentive for average or even above average investors to put money into this industry (and the ability of shareholders to monitor corporations even when informational problems are much less severe appears to be problematic). If finance and large banks are as critical to the economy as Tyler claims, does he really want to take the chance of causing investors to shy away from this industry to the point where their willingness to invest falls short of what is optimal given full knowledge of the risks they face? On this score, I think the traditional banking sector approach of providing some form of depositor guarantee coupled with limits on risks that banks can take and insurance premiums to cover depositor losses and limit moral hazard is a better approach. There are difficulties with providing depositor guarantees in the shadow banking system, but as Morgan Ricks argues, there are ways to over come this problem (Gorton and Metrick also have a proposal involving improving the collateral banks hold as insurance against depositor losses).

But whatever we do, we need to get on with it. Despite the Dodd-Frank financial reform bill and its directive to address this issue, the problem of bank runs in the shadow system -- a key factor in the financial sector collapse -- has not yet been solved. Work on this is underway, and new reulations are in the works, but for now the problem has not yet been resolved.

Rogoff: Coronary Capitalism

Ken Rogoff on the need for government to intervene and overcome important market failures:

Coronary Capitalism, by Kenneth Rogoff, Commentary, Project Syndicate: A systematic and broad failure of regulation is the elephant in the room when it comes to reforming today’s Western capitalism. ... But is the problem unique to the financial industry...?

Consider the food industry... Obesity rates are soaring around the entire world... Of course,... there are numerous other examples, across a wide variety of goods and services, where one could find similar issues. Here, though, I want to focus on the food industry’s link to broader problems with contemporary capitalism...

True, market forces have spurred innovation, which has continually driven down the price of processed food, even as the price of plain old fruits and vegetables has gone up. That is a fair point, but it overlooks the huge market failure here.

Consumers are provided with precious little information through schools, libraries, or health campaigns; instead, they are swamped with disinformation through advertising. Conditions for children are particularly alarming..., children are co-opted by channels paid for by advertisements...

If our only problems were the food industry causing physical heart attacks and the financial industry facilitating their economic equivalent, that would be bad enough. But the pathological regulatory-political-economic dynamic that characterizes these industries is far broader. We need to develop new and much better institutions to protect society’s long-run interests.

Of course, the balance between consumer sovereignty and paternalism is always delicate. But we could certainly begin to strike a healthier balance than the one we have by giving the public far better information across a range of platforms, so that people could begin to make more informed consumption choices and political decisions.

I appreciate the sentiment, I've been a long-time advocate of more aggressive intervention to solve market failure problems myself, but was less excited about the particular example. Then, by chance, one of the next things I read was this:

Societal control of sugar essential to ease public health burden, EurekAlert: Sugar should be controlled like alcohol and tobacco to protect public health, according to a team of UCSF researchers, who maintain in a new report that sugar is fueling a global obesity pandemic, contributing to 35 million deaths annually worldwide from non-communicable diseases like diabetes, heart disease and cancer.

Non-communicable diseases now pose a greater health burden worldwide than infectious diseases... In the United States, 75 percent of health care dollars are spent treating these diseases and their associated disabilities.

In the Feb. 2 issue of Nature, Robert Lustig MD, Laura Schmidt PhD, MSW, MPH, and Claire Brindis, DPH, colleagues at the University of California, San Francisco (UCSF), argue that sugar ... is far from just "empty calories" that make people fat. At the levels consumed by most Americans, sugar changes metabolism, raises blood pressure, critically alters the signaling of hormones and causes significant damage to the liver – the least understood of sugar's damages. These health hazards largely mirror the effects of drinking too much alcohol, which ... is the distillation of sugar.

Worldwide consumption of sugar has tripled during the past 50 years and is viewed as a key cause of the obesity epidemic. But obesity ... may just be a marker for the damage caused by the toxic effects of too much sugar. This would help explain why 40 percent of people with metabolic syndrome—the key metabolic changes that lead to diabetes, heart disease and cancer—are not clinically obese.

"As long as the public thinks that sugar is just 'empty calories,' we have no chance in solving this," said Lustig, a professor of pediatrics,... and director of the Weight Assessment for Teen and Child Health (WATCH) Program at UCSF.

"There are good calories and bad calories...," Lustig said. "But sugar is toxic beyond its calories."

Limiting the consumption of sugar has challenges beyond educating people about its potential toxicity. "We recognize that there are cultural and celebratory aspects of sugar," said Brindis, director of UCSF's Philip R. Lee Institute for Health Policy Studies. "Changing these patterns is very complicated"

According to Brindis, effective interventions can't rely solely on individual change, but instead on environmental and community-wide solutions, similar to what has occurred with alcohol and tobacco, that increase the likelihood of success.

The authors argue for society to shift away from high sugar consumption, the public must be better informed about the emerging science on sugar.

"There is an enormous gap between what we know from science and what we practice in reality," said Schmidt, professor of health policy at UCSF...

Many of the interventions that have reduced alcohol and tobacco consumption can be models for addressing the sugar problem, such as levying special sales taxes, controlling access, and tightening licensing requirements on vending machines and snack bars that sell high sugar products in schools and workplaces.

"We're not talking prohibition," Schmidt said. "We're not advocating a major imposition of the government into people's lives. We're talking about gentle ways to make sugar consumption slightly less convenient, thereby moving people away from the concentrated dose. What we want is to actually increase people's choices by making foods that aren't loaded with sugar comparatively easier and cheaper to get."

Some of this was news to me (e.g. "significant liver damage"), so maybe there's more to the market failure in the food industry due to informational asymmetries claim than I thought.

How Did the Fed Get Things So Wrong?

We are, as they say, live:

How Did the Fed Get Things So Wrong?

It's about the Fed's mistakes before and during the crisis, and how it might improve going forward.

"Raskin Urges Penalties on Mortgage Servicers"

I talked to Jamie Galbraith briefly today at a session he was participating in here at the AEA meetings in Chicago -- he was a discussant on a panel talking, in part, about the problems in the financial sector that caused the crisis. More than anyone I know, Jamie has been asking why the F-word -- fraud -- is so absent from these discussion. I wasn't able to stay for his full remarks due to another commitment, but I thought about tweeting a bet that the word fraud would be used as some point during his presentation. I'm guessing he'd like this news:

Raskin Urges Penalties on Mortgage Servicers, Reuters: Federal Reserve Governor Sarah Bloom Raskin on Saturday said the Fed must impose monetary penalties on banks who entered into an April agreement with regulators over how to fix problems in their mortgage servicing businesses.

"The Federal Reserve and other federal regulators must impose penalties for deficiencies that resulted in unsafe and unsound practices or violations of federal law," Raskin said... "The Federal Reserve believes monetary sanctions in these cases are appropriate and plans to announce monetary penalties."

Raskin did not say when the penalties will be announced.

She said that "appropriately sized" penalties would "incentivize mortgage servicers to incorporate strong programs to comply with laws when they build their business models."...

Recess Appointments: Why Now?

On the news today that Obama will make a recess appointment to Richard Cordray to Head CFPB, Yves Smith says:

Obama to Make Recess Appointment of Richard Cordray to Head Consumer Financial Protection Bureau: ...This move raises the obvious question: why didn’t Obama make a recess appointment of Elizabeth Warren...? ...

I'd guess the administration would argue that the GOP hadn't yet crossed over some threshold of intransigence, this was part of a more general reelection strategy (plans to make three recess appointments to the NLRB were also announced), the political opportunity wasn't right, or something like that. But it's a good question -- why now instead of then (a question that can also be asked about Peter Diamond's nomination to the Federal reserve Board of Governors)? What it says to me is all that matters is Obama's reelection (see, for example, the pivot to deficit reduction) -- when the timing's right for that, things will happen -- but don't keep your fingers crossed otherwise. If you are unemployed and struggling, the president will try to help if it also helps him get reelected, but helping because it's the right thing to do? Not likely.

"An Elegant Core of Sensible Ideas"

Colleen Murray at Treasury Notes, the blog at the US Treasury, writes:

...the current calls to repeal the Dodd-Frank Act are a significant cause of the uncertainty that responsible business leaders are seeking to avoid.  Once it is fully implemented, the Dodd-Frank Act will improve market certainty, strengthen the financial system, and help boost the economy.

They are fighting against attempts to roll back financial regulation. I have no problem with that -- just wish they'd also noted that Dodd-Frank should be the beginning rather than the end of our efforts to reform the financial system. More is needed.

"Climate Change – Our Real Bequest to Future Generations"

Dean Baker:

Climate change – our real bequest to future generations, Commentary, by Dean Baker: It is remarkable how efforts to reduce the government deficit/debt are often portrayed as a generational issue, while efforts to reduce global warming are almost never framed in this way. ...

Seeing the debt as an issue between generations is wrong in almost every dimension. The ... debt is not money that our children and grandchildren will be paying to someone else. It is money that they will be paying to themselves. ...

Of course, some of this debt will be owned by foreigners. ... However, the foreign ownership of US financial assets, including government debt, is determined by our trade deficit, not our budget deficit.

Those who proclaim themselves concerned that our grandchildren will be stuck making huge payments to ... foreigners should be focused on reducing the value of the dollar. A more competitively priced dollar will be the key to ... reducing the outflow of dollars each year that are used to buy up US financial assets.

The main factor that will determine the economic wellbeing of our children and grandchildren will be ... the quality of the capital and infrastructure we pass onto them, along with the level of education we give them, the state of technical knowledge we achieve, and the state of the natural environment.

If we cut the deficit by making spending cuts ... in these areas, we will be making our children worse-off... Of course, leaving their parents unemployed for long periods of time will not improve our children's wellbeing either.

If the deficit has little to with the wellbeing of our children and grandchildren, global warming has everything to do with it. ... Global warming threatens to do far more damage to the wellbeing of future generations than the social security and Medicare benefits going to baby-boomers, no matter how much the deficit hawks try to twist the numbers to claim otherwise.

Paul Krugman: Springtime for Toxics

The EPA's new rules on mercury and other airborne toxics should produce large benefits -- if they can survive opposition from the GOP:

Springtime for Toxics, by Paul Krugman, Commentary, NY Times: Here’s what I wanted for Christmas: something that would make us both healthier and richer. And since I was just making a wish, why not ask that Americans get smarter, too?

Surprise: I got my wish, in the form of new Environmental Protection Agency standards on mercury and air toxics for power plants. ...

As far as I can tell, even opponents of environmental regulation admit that mercury is nasty stuff. It’s a potent neurotoxicant... The E.P.A. explains: “Methylmercury exposure is a particular concern for women of childbearing age, unborn babies and young children, because studies have linked high levels of methylmercury to damage to the developing nervous system, which can impair children’s ability to think and learn.”

That sort of sounds like something we should regulate, doesn’t it?

The new rules would also have the effect of reducing fine particle pollution, which is a known source of many health problems... The ... payoff to the new rules is huge: up to $90 billion a year in benefits compared with around $10 billion a year of costs in the form of slightly higher electricity prices. ...

And it’s a deal Republicans very much want to kill.

With everything else that has been going on in U.S. politics recently, the G.O.P.’s radical anti-environmental turn hasn’t gotten the attention it deserves. ... And I’m not exaggerating: during the fight over the debt ceiling, Republicans tried to attach riders that ... would essentially have blocked the E.P.A. and the Interior Department from doing their jobs. ...

More generally, whenever you hear dire predictions about the effects of pollution regulation, you should know that special interests always make such predictions, and are always wrong. For example, power companies claimed that rules on acid rain would disrupt electricity supply and lead to soaring rates; none of that happened, and the acid rain program has become a shining example of how environmentalism and economic growth can go hand in hand.

But again, never mind: mindless opposition to “job killing” regulations is now part of what it means to be a Republican. And I have to admit that this puts something of a damper on my mood: the E.P.A. has just done a very good thing, but if a Republican — any Republican — wins next year’s election, he or she will surely try to undo this good work.

Still, for now at least, those who care about the health of their fellow citizens, and especially of the nation’s children, have something to celebrate.

The GOP is Creating Uncertainty that Hurts the Economy

Menzie Chinn summarizes recent work on the economic impact of uncertainty. The bottom line -- that it's uncertainty about fiscal policy such as the GOP has created that hurts the economy -- is worth noting:

With the Republicans in the House maximizing policy uncertainty, I think it useful to recount some of the recent research on how uncertainty is affecting output...

For me, the policy conclusion emanating from all three of these pieces is that if there is important policy uncertainty, it is that related to fiscal policy. Empirical (i.e., econometric) evidence that regulatory uncertainty is important is, to my knowledge, non-existent. Hence, we can conclude that repeated crises over the raising of debt ceilings, continuing resolutions, and the like should be avoided.

Assessing the Climate Talks

Robert Stavins assess the Durban climate talks:

Assessing the Climate Talks — Did Durban Succeed?, by Robert Stavins: The 17^th Conference of the Parties (COP-17) of the United Nations Framework Convention on Climate Change (UNFCCC) adjourned on Sunday, a day and a half after its scheduled close, and in the process once again pulled a rabbit out of the hat by saving the talks from complete collapse (which appeared possible just a few days earlier).  But was this a success?

The Durban Outcome in a Nutshell

The outcome of COP-17 includes three major elements:  some potentially important elaborations on various components of the Cancun Agreements; a second five-year commitment period for the Kyoto Protocol; and (read this carefully) a non-binding agreement to reach an agreement by 2015 that will bring all countries under the same legal regime by 2020.

Is This a Success?

If by “success” in Durban, one means solving the climate problem, the answer is obviously “not close.”

Indeed, if by “success” one meant just putting the world on a path to solve the climate problem, the answer would still have to be “no.”

But, I’ve argued previously – including in my pre-Durban essay last month – that such definitions of success are fundamentally inappropriate for judging the international negotiations on the exceptionally challenging, long-term problem of global climate change.

The key question, at this point, is whether the Durban outcome has put the world in a place and on a trajectory whereby it is more likely than it was previously to establish a sound foundation for meaningful long-term action.

I don’t think the answer to that question is at all obvious, but having read carefully the agreements that were reached in Durban, and having reflected on their collective implications for meaningful long-term action, I am inclined to focus on “the half-full glass of water.”  My conclusion is that the talks – as a result of last-minute negotiations – advanced international discussions in a positive direction and have increased the likelihood of meaningful long-term action.  Why do I say this? ...[continue]...

Climate change legislation has all but dropped of the radar in the US political arena.

Danger Lurks in the Shadows

I've also complained about this off and on over the last year or so, and I'll feel better about the security of financial markets when the problem is finally addressed:

The Price of a Haircut, by Steve Landsburg: Yesterday I had the pleasure of attending a very good talk by Yale’s Gary Gorton on the origins of the financial crisis.

Gorton’s story is that this was a bank run, not substantially different from the bank runs that have always plagued capitalist economies. In this case, the run took place in the repo market, which is an unregulated (and largely unmonitored)... The repo market serves large institutions (e.g. Fidelity Investments or state governments) with a lot of cash on hand that they want to stash in an interest-bearing account for a day or two. So Fidelity deposits, say, a half-billion dollars at, say, Bear Stearns, just as you might deposit five hundred dollars at your local bank. One difference, though, is that your account at your local bank is insured, whereas Fidelity’s account at Bear Stearns is not — so Fidelity, unlike you, demands collateral for its deposit. Bear Stearns complies by handing over a half-billion dollars worth of bonds, of which Fidelity takes physical possession. The next morning, Fidelity withdraws its money and returns the bonds.

The problem comes in when rumors begin to spread that some bonds might be riskier than they appear, and Fidelity starts to worry that maybe Bear Stearns is picking particularly risky bonds to hand over. Therefore Fidelity demands more than a half-billion in bonds to guarantee its half-billion dollar deposit. If there’s, say, a 10% discrepancy between the deposit and the collateral, we say that Bear Stearns has taken a half-billion dollar haircut.

Because Bear Stearns has a fixed quantity of bonds on hand, and because all of its depositors are demanding haircuts, Bear Stearns can now accept fewer deposits than before. This means that Bear Stearns has less cash on hand. This makes depositors even more worried about the security of their deposits, which means they demand larger haircuts. The effects snowball until Bear Stearns collapses. ...

So what should we do about all this? Gorton, along with his colleague Andrew Metrick, argues that the repo market, like any banking market, is inherently susceptible to runs and therefore ought to be regulated. In this case, the regulations should focus on insuring the availability of sufficient high-quality collateral to keep depositors calm. Gorton observes that the existing policy responses to the crisis (e.g. the Dodd-Frank bill) do pretty much nothing to address this fundamental need. The Gordon/Metrick paper contains some specific proposals, which unfortunately Gorton never got to in yesterday’s talk. ...

Insuring the availability of high-quality collateral is not the only solution. For example, the shadow banking system could also be regulated much like the traditional banking system where limits on risk taking behavior and insurance fees are traded for deposit insurance (see here for an email from Metrick on this, the limits on risk-taking and the fees are intended to counter the moral hazard that arises with the deposit insurance). Regulators are supposedly working on this, and a solution involving collateral restrictions is the likely outcome, but so far the vulnerability persists.

The Source of Cronyism Is *Not* Social Programs for the Poor

Jeff Sachs:

Fairness and the Occupy Movement Revisited, by Jeff Sachs: A recent Wall Street Journal article by Arthur C. Brooks on the Occupy Movement and fairness says some interesting things about potential common ground between free-market ideas and the Occupy movement. Yet Brooks also commits some very important errors. ...

Brooks, the head of the American Enterprise Institute, denounces crony capitalism as the dark side of American politics and economics. On this we should all agree. The level of corruption in Washington is staggering, growing, and rife in both parties. ...

The Republicans answer to crony capitalism is to slash government. Yet by this they mean mainly an attack on the remaining social programs. This is a kind of bait-and-switch strategy: rev up the anger against government corruption, and then kill the life-support programs of the poor and working class. Crony capitalism exists mainly in the big-ticket sectors of the economy -- banking, oil, real estate, private health insurance, military contractors, and infrastructure -- not in the essential but much smaller parts of the economy: malnutrition of poor children, lack of quality pre-school, insufficient job training, and inadequate student loan coverage.

Yes, crony capitalism should be confronted anywhere in the economy, yet cutting the life-support systems for the working class and poor won't fix government, but instead would cripple the prospects of more than 100 million poor and near-poor Americans. To control crony capitalism, we need to direct our attention where it belongs: the wealth-support systems of the rich, not the life-support systems of the poor. ...

Yes, Mr. Brooks, let us find common ground. We all agree on the need to end crony capitalism. But let us also work together not to cripple government but to make it work for all Americans.

The hope for common ground where there is none can lead to Obama like one-sided concessionary behavior, and we have more than enough of that already. Yes, let's find common ground where it exists, but let's also be careful not to try to meet in the middle when the other side is pursuing a bait and switch strategy. The Republican goal of reducing the size of government through reductions in social programs is unwavering, and they will pursue any argument handy at the moment to bring this about. In recessions, they tell us tax cuts are needed to stimulate the economy, but the real goal is to cut funding for the government permanently. Once the taxes are reduced, they won't agree to increase them again (unless it's to protect their cronies, i.e. an increase in payroll taxes is fine so long as it prevents the increase in taxes on the wealthy needed to fund it). In normal times, we're told tax cuts stimulate economic growth even though there's not much evidence to support this claim. Presently, it's the cronyism argument, and tomorrow it will be something else. The Republicans have their eyes on the ball, and the rules of the game are to be adjusted as necessary to allow them the best opportunity to take the ball across the goal line. Winning is all that matters. Fairness for both sides playing the game, etc. has nothing to do with it and we'd be wise to keep our eyes on the ball as well.

The other thing to note is that the location of common ground has shifted to the right from where it used to be. "Meet us in the middle" now means meeting on ground that would have been considered on the right not all that long ago. Democrats have already conceded too much in the ideological war, and there comes time when leaders in the party must take a stand and hold their ground. That time is long past.

"The Easy Question in Financial Regulation"

Jeff Frankel:

The Easy Question in Financial Regulation, by Jeff Frankel: Many questions in the field of financial regulation are hard to answer: Would the separation of commercial banking and investment banking help prevent crises? To what extent should individual consumers be protected against foolishly borrowing too much? Should Credit Default Swaps be regulated out of existence? What should regulators do about patterns of high executive compensation that is evidently not a reward for performance? I have views on these questions, just as other observers do. But in these cases I see the arguments on both sides.

The question of funding the U.S. financial regulators, the Securities and Exchange Commission or the Commodity Futures Trading Commission, is easy to answer, however. I do not see the argument for cutting funding of the SEC and CFTC or for the other ways that Republicans in Congress are finding to make it difficult for these agencies to do their jobs. They are also deliberately impeding two new agencies set up in response to the 2008 financial crisis — the Consumer Financial Protection Bureau, lodged at the Fed, and the Office of Financial Research at the Treasury — from doing their respective jobs.

Bernard Madoff was the most obviously venal of the figures in the financial crisis of the fall of 2008. ... The SEC had been warned over and over again in the years before 2008. Why did it do nothing? In large part because it had been given a mandate in effect to regulate as little as possible.

I realize that in the United States, as in every country, we have some regulations that are excessive or undesirable. But how anyone can think that regulation by the SEC was excessive during 2001-08 and that this contributed to the financial crisis?

That is the irrationality on the Right. There is an equally irrational point of view on the Left. It goes like this: because the head of the CFTC is a former investment banker from Goldman Sachs, it must necessarily be that he is serving the interests of the financial community. It happens that Gary Gensler is doing a great job, against great odds. He has been trying to force derivatives trading into clearinghouses with lower counterparty risk, as required by the Dodd-Frank bill, to try to avoid repeats of September 2008. I can see, when an investment banker is appointed to such a position, asking questions that one would not ask otherwise. But he has been in office for 2 ½ years, pursuing regulation of derivatives with sufficient vigor to make most of Wall Street angry. Reading the words "Goldman Sachs" on someone’s resume should not be a substitute for all other thought processes.

Prosecutions for Bank Fraud

More here.

The Concentration of Economic Power

I am going to have to plead not guilty to the charge that "mainstream and left-wing economists" should be criticized "for their lack of attention to monopoly power." I've also wondered many times why this issue doesn't get more attention and, more importantly, why the increasing concentration of power doesn't draw more action from regulators:

Who Rules the Global Economy?, by Nancy Folbre, Commentary, NY Times: ...Three Swiss experts on complex network analysis have recently examined the architecture of international ownership, analyzing a large database of transnational corporations. They concluded that a large portion of control resides with a relatively small core of financial institutions, with about 147 tightly knit companies controlling about 40 percent of the total wealth in the network. ... An article in the British magazine New Scientist describes the research as evidence of a global financial oligarchy. ...

A recent article in the socialist journal Monthly Review, by John Bellamy Foster, Robert W. McChesney and R. Jamil Janna, criticizes both mainstream and left-wing economists for their lack of attention to monopoly power.

Focusing on the United States, they note that the percentage of manufacturing industries in which the largest four companies account for at least 50 percent of shipping value has increased to almost 40 percent, up from about 25 percent in 1987.

Even more striking is the increase in retail consolidation, largely reflecting a “Wal-Mart effect.” In 1992, the top four companies accounted for about 47 percent of all general merchandise sales. By 2007, their share had reached 73.2 percent.

Banking, however, takes the cake. Citing my fellow Economix blogger Simon Johnson, the Monthly Review article notes that in 1995, the six largest bank-holding companies (JPMorgan Chase, Bank of America, Citigroup, Wells Fargo, Goldman Sachs and Morgan Stanley) had assets equal to 17 percent of gross domestic product in the United States. By the third quarter of 2010, this had risen to 64 percent. ...

Public concerns about economic concentration are stoked by hard times. Congress authorized a full-scale investigation of the topic back in days of the Great Depression. Seems like the time has come for a fully international update.

"Wall Street Won Another Battle"

 Regulatory capture:

As Regulators Pressed Changes, Corzine Pushed Back, and Won, by Azam Ahmed and Ben Protess, NY Times: Months before MF Global teetered on the brink, federal regulators were seeking to rein in the types of risky trades that contributed to the firm’s collapse. But they faced opposition from an influential opponent: Jon S. Corzine, the head of the then little-known brokerage firm.

As a former United States senator and a former governor of New Jersey, as well as the leader of Goldman Sachs in the 1990s, Mr. Corzine carried significant weight in the worlds of Washington and Wall Street. While other financial firms employed teams of lobbyists to fight the new regulation, MF Global’s chief executive in meetings over the last year personally pressed regulators to halt their plans.

The agency proposing the rule, the Commodity Futures Trading Commission, relented. Wall Street, which has been working to curb many financial regulations, won another battle.

Yet with ... $630 million in missing customer funds, Mr. Corzine’s effort may come back to haunt him.

The proposed rule would have restricted a complicated transaction that allowed MF Global in essence to borrow money from its own customers. ... While such financing is not unknown on Wall Street, it carries substantial risk. ... Regulators are now examining whether these transactions explain the missing money at MF Global. ...

Stavins: The Promise and Problems of Pricing Carbon

Robert Stavins:

The Promise and Problems of Pricing Carbon, by Robert Stavins: Friday, October 21^st was a significant day for climate change policy worldwide and for the use of market-based approaches to environmental protection, but it went largely unnoticed across the country and around the world, outside, that is, of the State of California.  On that day, the California Air Resources Board voted unanimously to adopt formally the nation’s most comprehensive cap-and-trade system, intended to provide financial incentives to firms to reduce the state’s greenhouse gas (GHG) emissions, notably carbon dioxide (CO₂) emissions, to their 1990 level by the year 2020...  Compliance will begin in 2013, eventually covering 85% of the state’s emissions.

This policy for the world’s eighth-largest economy is more ambitious than the much heralded (and much derided) Federal policy proposal – H.R. 2454, the Waxman-Markey bill – that was passed by the U.S. House of Representatives in June of 2009, and then died in the U.S. Senate the following year.  With a likely multi-year hiatus on significant climate policy action in Washington now in place, California’s system – which will probably link with similar cap-and-trade systems being developed in Ontario, Quebec, and possibly British Columbia – will itself become the focal point of what may evolve to be the “North American Climate Initiative.” ...

What Lies in the Future?

...Because a truly meaningful climate policy – whether market-based or conventional in design – will have significant impacts on economic activity in a wide variety of sectors and in every region of a country, proposals for these policies inevitably bring forth significant opposition, particularly during difficult economic times.

In the United States, political polarization – which began some four decades ago, and accelerated during the economic downturn – has decimated what had long been the key political constituency in the Congress for environmental action, namely, the middle, including both moderate Republicans and moderate Democrats.  Whereas Congressional debates about environmental and energy policy had long featured regional politics, they are now fully and simply partisan.  In this political maelstrom, the failure of cap-and-trade climate policy in the U.S. Senate in 2010 was essentially collateral damage in a much larger political war.

It is possible that better economic times will reduce the pace – if not the direction – of political polarization.  It is also possible that the ongoing challenge of large budgetary deficits in many countries will increase the political feasibility of new sources of revenue.  When and if this happens, consumption taxes (as opposed to traditional taxes on income and investment) could receive heightened attention, and primary among these might be energy taxes, which can be significant climate policy instruments, depending upon their design.

That said, it is probably too soon to predict what the future will hold for the use of market-based policy instruments for climate change.  Perhaps the two decades we have experienced of relatively high receptivity in the United States, Europe, and other parts of the world to cap-and-trade and offset mechanisms will turn out to be no more than a relatively brief departure from a long-term trend of reliance on conventional means of regulation.  It is also possible, however, that the recent tarnishing of cap-and-trade in U.S. political dialogue will itself turn out to be a temporary departure from a long-term trend of increasing reliance on market-based environmental policy instruments.  It is much too soon to say.

[There's much more on this in the original post.]

Regulatory Uncertainty is Not the Problem

The Treasury Department's new chief economist, Jan Eberly, says regulatory uncertainty is not the cause of slow job growth:

 Is Regulatory Uncertainty a Major Impediment to Job Growth?, by Dr. Jan Eberly, Treasury Notes: Last week at a Senate hearing Secretary Geithner said, “I'm very sympathetic to the argument you want to be careful to get the rules better and smarter, but I don’t think there's good evidence in support of the proposition that it's regulatory burden or uncertainty that's causing the economy to grow more slowly than any of us would like.”

Economists from across the political spectrum have also weighed into this debate and reached the same conclusion. ... Nonetheless, two commonly repeated misconceptions are that uncertainty created by proposed regulations is holding back business investment and hiring and that the overall burden of existing regulations is so high that firms have reduced their hiring.

If regulatory uncertainty was a major impediment to hiring right now, we would expect to see indications of this in one or more of the following: business profits; trends in the workforce, capacity utilization, and business investment; differences between industries undergoing significant regulatory changes and those that are not; differences between the United States and other countries that are not undergoing the same changes; or surveys of business owners and economists.  As discussed in a detailed review of the evidence below, none of these data support the claim that regulatory uncertainty is holding back hiring. ...

A Ticker-Tape Parade?

This caught my eye:

Simon Johnson ... said that a current member of the Fed told him he was “disappointed there hadn’t been a ticker-tape parade” for policymakers who, in the central banker’s mind, had saved the economy.

Suppose the fire department fails to do adequate inspections, and a big fire breaks out because of it. If that same fire department puts it out and saves the day, do we cheer them for cleaning up their own mess? I think not.

Cheney's Fracking "Halliburton Loophole"

 Another Bush administration gift that keeps on giving:

Safety First, Fracking Second, The Editors, Scientific American: A decade ago layers of shale lying deep underground supplied only 1 percent of America’s natural gas. Today they provide 30 percent. Drillers are rushing to hydraulically fracture, or “frack,” shales in a growing list of U.S. states. ... The benefits come with risks, however, that state and federal governments have yet to grapple with.

Public fears are growing about contamination of drinking-water supplies from the chemicals used in fracking and from the methane gas itself. Field tests show that those worries are not unfounded. ... Yet states have let companies proceed without adequate regulations. They must begin to provide more effective oversight, and the federal government should step in, too.

Nowhere is the rush to frack, or the uproar, greater than in New York. ... Fracking is already widespread in Wyoming, Colorado, Texas and Pennsylvania.

All these states are flying blind. A long list of technical questions remains unanswered about the ways the practice could contaminate drinking water, the extent to which it already has, and what the industry could do to reduce the risks. ...

Scientific advisory panels at the Department of Energy and the EPA have enumerated ways the industry could improve and have called for modest steps, such as establishing maximum contaminant levels allowed in water for all the chemicals used in fracking. Unfortunately, these recommendations do not address the biggest loophole of all. In 2005 Congress—at the behest of then Vice President Dick Cheney​, a former CEO of gas driller Halliburton—exempted fracking from regulation under the Safe Drinking Water Act. Congress needs to close this so-called Halliburton loophole, as a bill co-sponsored by New York State Representative Maurice Hinchey would do. ...

The GOP's (Lack of a) Jobs Plan

The GOP wants to take us backwards:

GOP: ‘Deregulate Wall Street!’, by Ezra Klein: In recent days, more than 900 cities have hosted protests under the Occupy Wall Street banner. But the enthusiasm ... hasn’t trickled up to the GOP presidential campaign. There, the candidates want to leave Wall Street alone. ... They want to deregulate -- actively and aggressively.

“I introduced the bill to repeal Dodd-Frank,” bragged Rep. Rep. Michele Bachmann... But Herman Cain was not to be outdone. “Repeal Dodd-Frank, and get rid of the capital gains tax,” he countered. Repealing the capital gains tax would make it vastly more profitable to earn a living through investment income rather than wage income. A hedge-fund manager, for instance, might escape income taxation entirely. It would give smart, young college students even more reason than they have now to go into the hedge fund game than, say, medicine.

“Dodd-Frank obviously is a disaster,” agreed Rep. Ron Paul. “But Sarbanes-Oxley costs a trillion dollars, too. Let’s repeal that, too!” Sarbanes-Oxley ... is the law passed in the wake on the Enron scandals. It sought to make balance sheets more transparent and financial statements more trustworthy. It is not well liked by the financial sector.

Mitt Romney, while not quite as carefree in his denunciations of the financial-regulation reforms, largely agrees with his co-candidates. His jobs plan promises that a Romney presidency would “seek to repeal Dodd-Frank and replace it with a streamlined regulatory framework,” though it doesn’t give much detail on what that streamlined framework would be. He also says that “the Sarbanes-Oxley law passed in the wake of the accounting scandals of the early 2000s should also be modified as part of any financial reform.”

So three years after the worst financial crisis since the Great Depression, the consensus in the Republican Primary is that we should deregulate Wall Street not just to where it was before the bubble burst, but to somewhere nearer to where it was before Enron crashed. ...

Romney's jobs plan is to repeal Dodd-Frank? Speaking of jobs, how about the GOP jobs plan?:

Republicans Getting a Pass on Their Jobs Plans, by Kevin Drum: Greg Sargent wants to know why the media is giving Republicans a huge pass on their various "jobs plans":

Obama and the Senate GOP have both introduced jobs plans. In reporting on the Senate plan, many news organizations described it as a “GOP jobs plan.” And that’s fine — Rand Paul said it would create five million of them. But few if any of the same news orgs that amplified the GOP offering of a jobs plan are making any serious effort to determine whether independent experts think there’s anything to it. And independent experts don’t think there’s anything to it — they think the GOP jobs plan would not create any jobs in the near term, and could even hurt the economy. By contrast, they do think the Obama plan would create jobs and lead to growth.

Why aren’t these facts in every single news story about the ongoing jobs debate? Why aren’t they being broadcast far and wide? ...

I ... suspect that reporters are simply so used to Republicans embracing nonsense that they evaluate it on a whole different plane than they do "serious" proposals. GOP campaign plans are treated more as optics than as actual policy, as ways to signal a candidate's conservative bona fides more than as blueprints for actual legislation.

But Greg is right: this should stop. There's no reason to give these guys a pass on their laughable jobs plans that virtually no one thinks will create any actual jobs. ...

Perry's jobs program -- have people drill holes in the ground and then, for the most part, fill them up again -- sounds quite Keynesian. But it's mostly a way to argue for deregulation of his bread and butter, the energy industry, rather than a serious job creation proposal (the claim that it is a favor to the energy industry rather than a serious jobs proposal is bolstered by the other leg of his jobs plan, to dismantle the Environmental Protection Agency). This is characteristic of all the GOP jobs proposals -- pick something that you don't like, the EPA, Dodd-Frank, health care legislation, Sarbanes-Oxley, etc. -- and then argue that eliminating it will create jobs. Then wait for the press to report it as a serious job creation proposal (or at least fail to point out that the claims can't withstand scrutiny).