Category Archive for: Regulation [Return to Main]

Monday, April 29, 2013

Have Blog, Will Travel: Milken Global Conference

I am here today (Milken Global Conference 2013).

One quick first impression based upon the schedule of sessions. In the last few years, two or three years ago more so than last year, there were quite a few "soul-searching" sessions from the financial industry. How did financial markets fail, how can they be fixed, etc. That's not to say that there wasn't a lot of resistance to regulation from the industry, but they were at least dealing with the main issues, there was an attempt at an honest appraisal from many, and there were quite a few sessions on the topic.

There are sessions on regulation this year -- I'm currently in one called "Global Financial Regulation" (usual TBTF discussion so far, just turning to leverage) -- but compared to previous years the main concern now appears to be where we are headed in the next few years, opportunities for investment, etc. I suppose that's good news for the economy, but for financial stability? There's still a lot of work to be done, and an eroding will to do it.

Wednesday, April 17, 2013

'Financial Stability Monitoring'

In order to stabilize the financial system, there are two recommendations that I would definitely make. One is to reduce the chance of runs in the shadow banking system -- a key factor behind the financial crisis. As noted below, the Dodd-Frank Act "does not address structural problems in wholesale short-term funding markets, such as the susceptibility of money market funds to investor runs or the inherent fragility of repo markets." Regulators have been working on fixes for this problem, but it's not fixed yet and that should be a bit more alarming than it seems to be.

The other change is to develop a better early warning system for financial crises. Dean Baker would say just call me, but I'd like to go beyond that and develop new tools, statistics, etc. that can help us do a better job of identifying risks before they become destructively large. I won't be satisfied with the excuse that we can't predict bubbles reliably until we have done the work of trying to find better leading indicators for problems.

Those two changes are far from exhaustive, reducing leverage, for example, should be on the list as well. But they are key issues that need to be addressed and it's nice to see that the Fed recognizes this and is trying to develop a "broad and forward-looking monitoring program" (the problem of bank runs in the shadow banking system isn't directly addressed, the idea is to prevent problems through early detection coupled with a policy response to relieve the pressure in the market).

Before moving on to the paper, given recent developments surrounding the work of Reinhart and Rogoff, I should probably remind people of this:

NOTE: Staff working papers in the Finance and Economics Discussion Series (FEDS) are preliminary materials circulated to stimulate discussion and critical comment. The analysis and conclusions set forth are those of the authors and do not indicate concurrence by other members of the research staff or the Board of Governors.

Here's the abstract and introduction (on the continuation page) to the preliminary paper:

Financial Stability Monitoring, by Tobias Adrian, Daniel Covitz, and Nellie Liang, FRB Working Paper: Abstract While the Dodd Frank Act (DFA) broadens the regulatory reach to reduce systemic risks to the U.S. financial system, it does not address some important risks that could migrate to or emanate from entities outside the federal safety net. At the same time, it limits the types of interventions by financial authorities to address systemic events when they occur. As a result, a broad and forward-looking monitoring program, which seeks to identify financial vulnerabilities and guide the development of pre-emptive policies to help mitigate them, is essential. Systemic vulnerabilities arise from market failures that can lead to excessive leverage, maturity transformation, interconnectedness, and complexity. These vulnerabilities, when hit by adverse shocks, can lead to fire sale dynamics, negative feedback loops, and inefficient contractions in the supply of credit. We present a framework that centers on the vulnerabilities that propagate adverse shocks, rather than shocks themselves, which are difficult to predict. Vulnerabilities can emerge in four areas: (1) systemically important financial institutions (SIFIs), (2) shadow banking, (3) asset markets, and (4) the nonfinancial sector. This framework also highlights how policies that reduce the likelihood of systemic crises may do so only by raising the cost of financial intermediation in non-crisis periods.

Continue reading "'Financial Stability Monitoring'" »

Thursday, April 11, 2013

Did the Fed Cause the housing Bubble?

According to research by Ambrogio Cesa-Bianchi and Alessandro Rebucci, the housing bubble was caused by "regulatory rather than monetary-policy failures":

Is the Federal Reserve breeding the next financial crisis?, by Ambrogio Cesa-Bianchi and Alessandro Rebucci: Many economists think that the US Federal Reserve’s loose monetary stance in the 2000s fuelled the US housing bubble. Is the Fed thus responsible for the Global Crisis? This column discusses evidence suggesting that monetary policy was, in fact, not to blame. Rather, it was the absence of an effective regulatory function that created the mess we’re in now. It is not fair to blame the Great Recession only on the Fed’s monetary-policy stance nor is the Fed now breeding the next US financial crisis. ...
In the context of our model and according to this evidence, regulatory rather than monetary-policy failures are largely to blame for the occurrence and the severity of the Great Recession. Only by assuming that the Fed was the sole institutional guardian of financial stability, or at least the main one, is it possible to contend that monetary policy is to blame for the 2007-09 financial crisis and the ensuing Great Recession. ...

Tuesday, April 09, 2013

Solow: Has Financialization Gone Too Far?

Robert Solow has an essay that begins with lots of praise for Ben Bernanke:

How to Save American Finance from Itself: Has financialization gone too far?, by Robert Solow, TNR: Central banking is not rocket science, but neither is it a trivial pursuit. ... Running a central bank is in one way a little bit like flying a plane or sailing a boat: much of the time standard responses and small adjustments will do just fine, but every so often a situation arises in which fundamental understanding, knowledge of history, and good judgment can make the difference between riding out the storm and crashing. There was no such person in charge in 1929, and the result was disaster. There was one in 2008.
In his earlier scholarly life, Ben Bernanke, the chairman of the Federal Reserve Board, had been a careful student of the general interaction between the financial system and the real economy and especially of its working out in the Great Depression of the 1930s. So he had done his homework. His decisive and innovative actions at the Fed saved our economy from free fall with a possibly catastrophic end. ...

He goes on to review a book of four lectures Ben Bernanke gave on the role of the Fed:

In March 2012, George Washington University invited Bernanke to give four lectures as part of a course devoted to the role of the Federal Reserve in the economy. The lectures are now reproduced in book form, apparently from lightly edited transcripts. Each lecture ends with half a dozen questions from anonymous “students” and Bernanke’s answers. Some of the questions are smart, some less so, in which case Bernanke exhibits the professorial skill of seamlessly answering a slightly different question. ...
The lectures are consistently lucid and informal—maybe a little too anecdotal, but illustrated with many clear and informative slides—and above all intelligent and interesting. There are no revelations or recantations; even if Bernanke had any in mind, this would not be the place for them. A short book such as this has no room for a play-by-play account of the crisis. But it would be difficult to find a better short and not very technical account of what went wrong, and of how the Fed (and the Treasury) managed to keep it from getting much worse. ...

He then goes through a long, detailed discussion of the issues Bernanke addresses in these lectures, but I want to pick it up again near the end:

Bernanke's ... preferred answer is better and more system-oriented regulation. One has to ask then why regulation failed to see the crisis of 2007–2008 coming and take action to head it off. Bernanke suggests that regulators were lulled into inattention by the so-called Great Moderation...
For safeguarding financial stability in the future, Bernanke seems to count heavily on the provision in Dodd-Frank that establishes a committee of regulators charged with keeping an eye on “systemically important” financial institutions, whatever they look like, in order to warn them away from dangerously risky behavior and/or impose extra capital requirements. We will have to see how that works out...
He touches on it only obliquely in these lectures, but Bernanke has lingering worries that the size, the complexity, and the interconnectedness of today’s financial system strain the capacity of even improved risk-management techniques to protect the system against its inherent vulnerabilities. ...
All of which leads to a broader issue... Any complicated economy needs a complicated financial system: to allocate dispersed capital to dispersed productive uses, to provide liquidity, to do maturity and risk transformation, and to produce market evaluations of uncertain prospects. If these functions are not performed adequately, the economy cannot produce and grow with anything like efficiency. Granted all that, however, the suspicion persists that financialization has gone too far.
What would that mean? It would mean that the last x percent of financial activity absorbs more resources (especially intellectual resources) and creates more potential instability than its additional efficiency-benefits can justify. This charmingly subversive suggestion is easy to make, but it is extremely difficult to validate. Yes, it is hard to imagine that the Hedge Fund Operator of the Year does anything that is remotely socially useful enough to justify the enormous (and lightly taxed) compensation that results; but that is not really an argument. Much more significant is the fact that the bulk of incremental financial activity is trading, and trading, while it may provide a little useful public information about market opinion, is largely a way to transfer wealth from those with inferior information and calculation ability to those with more. There is no enhancement of economic efficiency to speak of. This is, you might say, the $64 trillion question. Maybe I shouldn’t wish it on Ben Bernanke. 

Given his worries about financial stability, I have to wonder if the praise for Bernanke shouldn't be a bit more qualified. I agree that the Fed did a pretty good job responding the the recession. It could have done better -- it was frequently too late and too timid, especially during the first few years -- but it also could have done a whole lot worse. But what we don't yet know is how well we have been insulated from future shocks. Is Bernanke's view correct about what is needed on the regulatory front, and has it been implemented? In my view, significant vulnerabilities remain within the shadow banking system (and I'm far from alone). If that's true and we do have another crisis down the road, then the effusive praise for Bernanke will diminish much as happened with Greenspan (anointed as the best Fed Chair ever only to have housing bubble crash dramatically change the view of his record). As Robert Solow says about Bernanke's views on safeguarding financial stability in the future, "We will have to see how that works out.

'Let the Punishment Fit the Crime of the Recession'

We are, as they say, live:

Let the Punishment Fit the Crime of the Recession, by Mark Thoma: As Paul Krugman observed recently,  “the urge to see depression as a necessary and somehow even desirable punishment for past sins, while inveighing against any attempt to mitigate suffering — is as strong as ever.”  Many of those who see our economic problems in these terms believe the sin we committed is too much debt fueled consumption and government spending. According to this view punishments such as austerity and high levels of unemployment provide a moral lesson that helps to prevent us from making the same mistakes again.
This is bad economics and it has the moral lesson all wrong. ...

Thursday, April 04, 2013

Thinking Straight About Debt

Paul Krugman on something I emphasized in a recent post, the danger of "excessive leverage":

Thinking Straight About Debt: A heads-up: I’m doing This Week this week. Also on the panel: David Stockman. This should be, um, interesting.
So, a few more thoughts on debt and what it does and doesn’t signify. ...
This is how you want to think about debt: it’s not a burden on the nation’s resources, because it’s mainly money we owe to ourselves, and it’s a problem not because we have to tighten our belt but because debt is currently leading to spending that’s less than we need to maintain full employment.
I would add that ... the ... debt of financial intermediaries ... is a big part of the real story and if anything bears even less resemblance to the notion of debt as a consequence of national overspending; to a large extent it’s just an accounting issue, because old-fashioned deposits aren’t counted as debt even though they are.
Maybe a short way to put all this is to say that we have a real problem with excessive leverage; that’s not at all the same thing as the nation being deeply in hock to some external player or players. And failing to understand that difference is a way to get both the nature of our crisis and the shape of appropriate policies totally wrong.

'Don’t Panic – Financial Reform is Coming'

Barney Frank is confident that new financial regulation "will be completed in time to prevent the type of crises that they are intended to prevent":

Don’t panic – financial reform is coming to America, by Barney Frank, Commentary, Financial Times: We are going to sort out the US financial system. This might seem a bold statement when, two and a half years after the Dodd-Frank Act was signed into law, much necessary regulation is still not on the books. But with the re-election of Barack Obama, I have no doubt that the necessary new rules will be in place in good time. ... Some of the factors responsible for the pace were inherent in the task. ...
This brings us to the set of obstacles to filling out the rule book... First, the SEC and the CFTC receive vast amounts of comments for each proposed rule, which they must process. Meanwhile, the Republican House appropriations committee starves them of money. ...
This is where the DC courts come in. Not only do these agencies have to go through comments, the court then grades their work... On several occasions, DC courts have struck down SEC and CFTC rules, not because of any constitutional problem, but because the conservative judges think the agencies have given too little deference to the financial industry’s arguments.
Documenting decisions to the degree that the court requires would be difficult in any circumstance. Doing so with ... Republican underfunding is impossible. This was, in part, what was at stake when the Republican Senate minority filibustered to death an Obama appointee to the DC circuit. ...
The rules will be completed in time to prevent the type of crises that they are intended to prevent, but later than they should be. But the fault for that will rest with Republican appropriators withholding adequate funding and Republican senators filibustering to maintain the DC circuit as a rightwing bastion.

I am not as confident as he is that we will get the rules we need. In addition, notice that he talks about preventing financial crisis. However, we can never fully prevent a financial collapse, only make it less likely. Thus, there is another aspect of regulation that is just as important as trying to prevent problems from occurring, building systems that are robust to shocks. Leverage is a good example. Limiting leverage can limit the "unwind" that occurs with large negative financial shocks and thus limit the downside risk.

The recent financial collapse surely illustrated that we need better regulation to reduce the chances of financial collapse, but it also illustrated -- starkly -- that the sorts of shock absorbers we should have in place are missing. Yes, things like limiting leverage will be resisted mightily by the industry and the politicians in the financial industry's pocket, but this type of protection for the system is just as important as trying to prevent problems in the first place.

Joel Waldfogel's Ambilavence about Amazon’s Acquisition of Goodreads

Joel Waldfogel on the economics of Amazon's purchase of Goodreads:

Am I the Only One Ambivalent about Amazon’s Acquisition of Goodreads?, by Joel Waldfogel: The New York Times reported recently that Amazon’s buying Goodreads, the largest book review site online. It’s easy to see the appeal of Goodreads to Amazon. Goodreads apparently has 10 million ratings and reviews of over 700,000 titles. ...
But when I think about Amazon’s sources of market power in book retailing, one of the first things that comes to mind is the indirect network effects: Amazon’s existing collection of user-contributed book ratings and reviews provide lots of information to potential buyers. The more customers who use Amazon, the more information they make available, and the higher the quality of subsequent customer experience at Amazon. In short, the more that people use Amazon, the more that additional people will want to use Amazon. This source of market power is fairly gained, I guess, although the customer/reviewers who create all of this information might want more compensation than the words “top-rated reviewer” after their names.
Buying Goodreads substantially increases the amount of information at Amazon’s disposal. Given how adroit Amazon is at using information, we can expect them to find a way to improve the customer experience. Some part of me is actually excited about that.
But Amazon’s acquisition of Goodreads will also enhance the market position of the market’s largest player. If Amazon owns Goodreads, then no other book retailer does. It seems entirely possible that some other book retailer could have combined with Goodreads to offer Amazon some serious competition. If this is a done deal, we’ll never know.

Tuesday, April 02, 2013

'Dark Pool Trading'

Hmmm: -- anyone want to convince me this is not something regulators should worry about?:

... The portion of all stock trading taking place away from the public exchanges hit new highs over the last few weeks, amounting to close to 40 percent on several days, up from an average of 16 percent in 2008 ...

'Olivier Blanchard’s Five Lessons for Economists From the Financial Crisis'

Long, long travel day today (and not sure if I'll have an internet connection), so -- for now -- a few quick ones (between here and today's links). First, Brad Delong sends us to David Wessel, who sends us to Olivier Blanchard (I've shortened the five points):

Olivier Blanchard’s Five Lessons for Economists From the Financial Crisis: ...Here are Mr. Blanchard's five lessons in his own words, lightly edited by The Wall Street Journal’s David Wessel:
1. Humility is in order: The Great Moderation ... convinced too many of us that the large-economy crisis -­ a financial crisis, a banking crisis ­- was a thing of the past. It wasn’t going to happen again... My generation ... knew how to do things better, not only in economics but in other fields as well. What we have learned is that's not true. History repeats itself. We should have known.
2. The financial system matters — a lot: It’s not the first time that we¹re confronted with ... “unknown unknowns”... There is another example in macro-economics: The oil shocks of the 1970s... It took a few years, more than a few years, for economists to understand what was going on. After a few years, we concluded that we could think of the oil shock as yet another macroeconomic shock. We did not need to understand the plumbing. We didn’t need to understand the details of the oil market. ...
This is different. What we have learned about the financial system is that the problem is in the plumbing and that we have to understand the plumbing..., it's very clear that the details of the plumbing matter.
3. Interconnectedness matters: This crisis started in the U.S. and across the ocean in a matter of days and weeks. Each crisis, even in small islands, potentially has effects on the rest of the world. The complexity of the cross border claims by creditors and by debtors clearly is something that many of us had not fully realized..., which countries are safe havens, and when and why? Understanding this has become absolutely essential. What happens in one part of the world cannot be ignored by the rest of the world. ...

It’s also true on the trade side. ... One absolutely striking fact of the crisis is the collapse of trade in 2009. Output went down. Trade collapsed. Countries which felt they were not terribly exposed through trade turned out to be enormously exposed.
4. We don’t know if macro-prudential tools work: It’s very clear that the traditional monetary and fiscal tools are just not good enough to deal with the very specific problems in the financial system. This has led to the development of macro-prudential tools... [Macroprudential tools allow a central bank to restrain lending in specific sectors without raising interest rates for the whole economy, such as increasing the minimum down payment required to get a mortgage, which reduces the loan-to-value ratio.] ... If there is a problem somewhere you can target the tool at the problem and not use the policy interest rate, which basically is kind of an atomic bomb without any precision.
The big question here is: How reliable are these tools? How much can they be used? The answer ... is this: They work but they don’t work great. People and institutions find ways around them. In the process of reducing the problem somewhere you tend to create distortions elsewhere.
5. Central bank independence wasn’t designed for what central banks are now asked to do: ... One of the major achievements of the last 20 years is that most central banks have become independent of elected governments. Independence was given because the mandate and the tools were very clear. The mandate was primarily inflation... The tool was some short-term interest rate that could be used by the central bank to try to achieve the inflation target. In this case, you can give some independence to the institution in charge of this because the objective is perfectly well defined, and everybody can basically observe how well the central bank does.
If you think now of central banks as having a much larger set of responsibilities and a much larger set of tools, then the issue of central bank independence becomes much more difficult. Do you actually want to give the central bank the independence to choose loan-to-value ratios without any supervision from the political process. Isn’t this going to lead to a democratic deficit in a way in which the central bank becomes too powerful? I'm sure there are ways out. Perhaps there could be independence with respect to some dimensions of monetary policy -­ the traditional ones — and some supervision for the rest or some interaction with a political process.

Friday, March 29, 2013

'Is 'Intellectual Property' a Misnomer?'

Tim Taylor:

Is "Intellectual Property" a Misnomer?, by Tim Taylor: The terminology of "intellectual property" goes back to the eighteenth century. But some modern critics of how the patent and copyright law have evolved have come to view the term as a tendentious choice. One you have used the "property" label, after all, you are implicitly making a claim about rights that should be enforced by the broader society. But "intellectual property"  is a much squishier subject than more basic applications of property, like whether someone can move into your house or drive away in your car or empty your bank account. ...
Is it really true that using someone else's invention is the actually the same thing as stealing their sheep? If I steal your sheep, you don't have them any more. If I use your idea, you still have the idea, but are less able to profit from using it. The two concepts may be cousins, but they not identical. 

Those who believe that patent protection has in some cases gone overboard, and is now in many industries acting more to protect established firms than to encourage new innovators, thus refer to "intellectual property as a "propaganda term." For a vivid example of these arguments, see "The Case Against Patents," by Michele Boldrin and David K. Levine, in the Winter 2013 issue of my own Journal of Economic Perspectives. (Like all articles in JEP back to the first issue in 1987, it is freely available on-line courtesy of the American Economic Association.)

Mark Lemley offers a more detailed unpacking of the concept of "intellectual  property" in a 2005 article he wrote for the Texas Law Review called "Property, Intellectual Property, and Free Riding" Lemley writes: ""My worry is that the rhetoric of property has a clear meaning in the minds of courts, lawyers and commentators as “things that are owned by persons,” and that fixed meaning will make all too tempting to fall into the trap of treating intellectual property just like “other” forms of property. Further, it is all too common to assume that because something is property, only private and not public rights are implicated. Given the fundamental differences in the economics of real property and intellectual property, the use of the property label is simply too likely to mislead."

As Lemley emphasizes, intellectual property is better thought of as a kind of subsidy to encourage innovation--although the subsidy is paid in the form of higher prices by consumers rather than as tax collected from consumers and then spent by the government. A firm with a patent is able to charge more to consumers, because of the lack of competition, and thus earn higher profits. There is reasonably broad agreement among economists that it makes sense for society to subsidize innovation in certain ways, because innovators have a hard time capturing the social benefits they provide in terms of greater economic growth and a higher standard of living, so without some subsidy to innovation, it may well be underprovided.

But even if you buy that argument, there is room for considerable discussion of the most appropriate ways to subsidize innovation. How long should a patent be? Should the length or type of patent protection differ by industry? How fiercely or broadly should it be enforced by courts? In what ways might U.S. patent law be adapted based on experiences and practices in other major innovating nations like Japan or Germany? What is the role of direct government subsidies for innovation in the form of government-sponsored research and development? What about the role of indirect government subsidies for innovation in the form of tax breaks for firms that do research and development, or in the form of support for science, technology, and engineering education? Should trade secret protection be stronger, and patent protection be weaker, or vice versa? 

These are all legitimate questions about the specific form and size of the subsidy that we provide to innovation. None of the questions about "intellectual property" can be answered yelling "it's my property." 

The phrase "intellectual property" has been around a few hundred years, so it clearly has real staying power and widespread usage  I don't expect the term to disappear. But perhaps we can can start referring to intellectual "property" in quotation marks, as a gentle reminder that an overly literal interpretation of the term would be imprudent as a basis for reasoning about economics and public policy. 

Monday, March 25, 2013

'Did the Iraq War Cause the Great Recession?'

Via Henry Farrell:

Did the Iraq War Cause the Great Recession?, Henry Farrell: Thomas Oatley thinks that it very plausibly did. His argument draws upon an interesting article (should be ungated) in the new issue of Perspectives on Politics, where he, Kindred Winecoff, Andrew Pennock and Sarah Bauerle Danzman argue that international political economy scholars pay too little attention to the structural characteristics of international politics. By concentrating too much on states as unitary actors, they fail to recognize the importance of the network connections between them. The network topology – the shape of the network – can have consequences – networks where no node gets very much more links than any other node are quite different in their consequences from networks where one or a couple of nodes receive a lot more links than others. This has implications for financial contagion – if contagion spreads across links, network topology will have important consequences for the likelihood of spread. As it turns out, there is strong reason to believe that the international financial system is one of the latter kinds of networks rather than one of the former. On two measures of financial ties, most countries on the periphery of the network have few links to other peripheral countries, but pretty well everyone has links to the US, and many have links to the UK too. ...[more]...

I'm not fully convinced by this theory that the Iraq war caused the recession, but it does bring up some important issue about network connectivity. Are highly interconnected networks better at dispersing risk? It depends upon the type of risk. Suppose a toxin hits a network. If diluting the toxin across the network also dilutes its effects to practically nothing, then we want the network to be as large and interconnected as possible. When shocks hit they will be quickly diluted and rendered relatively harmless. But for toxins that are deadly in minute doses, toxins that kill whatever they touch even when they are highly diluted, we want the infected node on the network to be isolated as much as possible.

Optimally, then, assuming that most shocks are not toxic if they are dispersed across a large network, we want the network to be large and highly interconnected so that risks can be diversified across the network to practically nothing. But we also want the ability to quickly disconnect nodes that become infected with toxins that don't lose their potency as they are diluted. And that's the problem, identifying when such a toxin hits a network is difficult -- there will always be denial if disconnecting nodes in the financial system costs people money -- and it may not be easy to quickly disconnect nodes from the network so that problem nodes can be isolated/quarantined before the toxin spreads.

We have been told that problems in places like Cyprus have been walled off -- nodes in the network have been isolated -- but so long as a few isolated connections still exist that are difficult to cut, highly toxic shocks can pollute the rest of the network. In addition, as we saw today when "Jeroen Dijsselbloem, the current head of the Eurogroup, held a formal, on-the-record joint interview with Reuters and the FT today, saying that the messy and chaotic Cyprus solution is a model for future bailouts" and financial markets reacted negatively (the statement is being walked back), some connections -- those involving expectations -- cannot be severed in any case.

Highly interconnected networks are highly desirable so long as (1) we can quickly identify trouble, and (2) nodes can be quickly and effectively isolated. But when those conditions are not present, the occasional highly toxic shock will cause quite a bit of damage.

Saturday, March 23, 2013

Robert Frank: Mixing Freedoms in a 32-Ounce Soda

I have a hard time getting excited about the Big Gulp thing (I live on Coke Zero straight from 2 liter bottles and massive amounts of coffee, take those away and I would get excited), but Robert Frank argues that the "Evidence suggests that the current high volume of soft-drink consumption has generated enormous social costs":

Mixing Freedoms in a 32-Ounce Soda, by Robert Frank, Commentary, NY Times:

To him, it hinges on this question: "Does frequent exposure to supersize sodas really limit parents’ freedom to raise healthy children?" He argues that it does, and asks "How do the benefits of your right to drink tax-free sodas outweigh the substantial costs of defending it?"

Taking as given that there really are "enormous social costs" from "supersize" soft drinks, I don't buy his argument that the peer effects undermining parental freedom are similar for large soft-drinks and cigarettes.

'He Who Makes the Rules'

On the run today so I haven't had time to do more than skim this quickly (it's relatively long), but this article on how financial regulation is quietly being watered down comes highly recommended:

He Who Makes the Rules, by Haley Sweetland Edwards, Washington Monthly: In late 2010, Bart Chilton, one of three Democratic commissioners at the U.S. Commodity Futures Trading Commission (CFTC), walked into an upper-floor suite of an executive office building to meet with four top muckety-mucks at one of the biggest financial institutions in the world. ...
The main topic ... was the CFTC’s pending rule on what are known as “position limits.” If implemented properly, position limits would put a leash on speculation in the commodities market by making it harder for heavyweight traders at places like Goldman Sachs and JPMorgan Chase to corner a market, make a killing for themselves, and screw up prices for the rest of us. Position limits are also one of many ways to tamp down the amount of risk big institutions can take on, which ... minimizes the chance taxpayers will have to bail them out. ...
The passage ... Dodd-Frank ... explicitly directs the CFTC to establish position limits... “The Commission shall by rule, regulation or order establish limits on the amount of positions, as appropriate,” it reads.
Still, even with the strength of the law behind him, Chilton waited until the end of the meeting to broach what he knew would be a tense subject. ... They deferred ... to their top lawyer, who explained that the ... CFTC was not required to establish position limits at all. ... Their lawyer quietly referred Chilton to the end of the sentence in question: as appropriate..., the statute can be interpreted as saying that the commission shall—but only if appropriate—establish position limits, he explained. ...
But it’s still, rather obviously, just that: a linguistic sleight of hand. The words “as appropriate” have appeared in statutes governing the CFTC’s authority to implement position limits for at least forty years without challenge. ...
The meeting ended abruptly... One of the muckety-mucks from the meeting walked with him to the elevator. ... Chilton turned to his host. “You guys have got to be kidding about this ‘as appropriate’ stuff, right?” he said. “I know,” the muckety-muck replied, admitting it was a stretch. He let out a little chuckle—“but that’s what we’re going with.” “He laughed,” Chilton told me recently, remembering that day. “He was laughing about how ludicrous it was.”
A couple of months after that inauspicious meeting, the CFTC released a proposed rule establishing position limits on oil, gas, coffee, and twenty-five other commodities markets. ... Finally, in October 2011, the CFTC issued a final rule. It was a victory, but a short-lived one. Two months later, two powerful industry groups ... hired Eugene Scalia, the son of Supreme Court Justice Antonin Scalia, as their lead counsel, and launched a lawsuit against the CFTC. ...
House Democrats and nineteen senators, some of whom had drafted Dodd-Frank, petitioned the court to rule in favor of the CFTC, a handful of op-eds beseeched judges to do the right thing, and financial reform advocates called foul. None of it made a difference. In September 2012, the U.S. Court for the District of Columbia Circuit overturned the CFTC’s rule. ...[more]...

Friday, March 22, 2013

Paul Krugman: Treasure Island Trauma

Despite the risks to financial stability, tax havens like Cyprus "are still operating pretty much the same way that they did before the global financial crisis":

Treasure Island Trauma, by Paul Krugman, Commentary, NY Times: A couple of years ago,... Nicholas Shaxson published a fascinating, chilling book titled “Treasure Islands,” which explained how international tax havens — which are also ... “secrecy jurisdictions” where many rules don’t apply — undermine economies around the world. Not only do they bleed revenues from cash-strapped governments and enable corruption; they distort the flow of capital, helping to feed ever-bigger financial crises.
One question Mr. Shaxson didn’t get into..., however, is what happens when a secrecy jurisdiction itself goes bust. That’s the story of Cyprus right now. ...
Now what? There are some strong similarities between Cyprus now and Iceland ... a few years back. Like Cyprus now, Iceland had a huge banking sector, swollen by foreign deposits, that was simply too big to bail out. Iceland’s response was essentially to let its banks go bust, wiping out those foreign investors, while protecting domestic depositors — and the results weren’t too bad. ...
Unfortunately, Cyprus’s response to its crisis has been a hopeless muddle. In part, this reflects the fact that it no longer has its own currency, which makes it dependent on decision makers in Brussels and Berlin — decision makers who haven’t been willing to let banks openly fail.
But it also reflects Cyprus’s own reluctance to accept the end of its money-laundering business; its leaders are still trying to limit losses to foreign depositors in the vain hope that business as usual can resume,... they ... tried to limit foreigners’ losses by expropriating small domestic depositors. As it turned out, however, ordinary Cypriots were outraged, the plan was rejected, and, at this point, nobody knows what will happen.
My guess is that, in the end, Cyprus will adopt something like the Icelandic solution... We’ll see.
But step back ... and consider the incredible fact that tax havens like Cyprus, the Cayman Islands, and many more are still operating pretty much the same way that they did before the global financial crisis. Everyone has seen the damage that runaway bankers can inflict, yet much of the world’s financial business is still routed through jurisdictions that let bankers sidestep even the mild regulations we’ve put in place. Everyone is crying about budget deficits, yet corporations and the wealthy are still freely using tax havens to avoid paying taxes like the little people.
So don’t cry for Cyprus; cry for all of us, living in a world whose leaders seem determined not to learn from disaster.

Tuesday, March 12, 2013

Can the Fed Burst the Next Bubble Before It’s Too Late?

The Fed is trying to figure out how to respond to asset price bubbles:

Can the Fed Burst the Next Bubble Before It’s Too Late?

The "Geenspan doctrine" is dead, but will it be replaced by the "Bernanke doctrine" or the "Stein doctrine"? I argue that both of these approaches miss an essential element for successful anti-bubble policy.

Thursday, March 07, 2013

'The Sordid History of Cap-and-Trade'

Richard Schmalensee and Robert Stavins on how "conservatives are choosing to demonize their own market-based creation" for addressing the market failures that lead to "large-scale environmental problems":

The sordid history of Congressional acceptance and rejection of cap-and-trade: Implications for climate policy, by Richard Schmalensee and Robert N. Stavins, Not so long ago, cap-and-trade mechanisms for environmental protection were popular in Congress. Now, such mechanisms are denigrated. What happened? This column tells the sordid tale of how conservatives in Congress who once supported cap and trade now lambast climate change legislation as ‘cap-and-tax’. Ironically, conservatives are choosing to demonize their own market-based creation. The successful conservative campaign that disparaged cap-and-trade means it may now be politically impossible to promote it in the US. The good news? Elsewhere, cap and trade is now a proven, viable option for tackling large-scale environmental problems. ...

Monday, February 25, 2013

'How To (Maybe) End Too Big To Fail'

This is from a St. Louis Fed write-up of the following Dialogue:

St. Louis Fed economist William Emmons led the Dialogue, titled “Robo-signing, the London Whale and Libor Rate-Rigging: Are the Largest Banks Too Complex for Their Own Good?” Joining Emmons for the Q&A that followed were Mary Karr, senior vice president and general counsel of the St. Louis Fed; Steven Manzari, senior vice president of the New York Fed’s Complex Financial Institutions unit; and Julie Stackhouse, senior vice president of Banking Supervision and Regulation at the St. Louis Fed. See the videos and Emmons’ presentation slides at

Here's the last part of the write-up on dealing with the too big to fail problem:

The Big Banks: Too Complex To Manage?, Central Banker, Winter 2012, FRB St. Louis:

... How To (Maybe) End “Too Big To Fail”

So, how will we deal with the megabanks? Emmons outlined two basic approaches: radical and incremental. The radical approach involves structural changes imposed on the banks themselves or the creation of a different legal definition of what a bank is and what it can do. Radical proposals include:

  • Reduce their complexity and size – Revive the 1933 Glass-Steagall Act (partially repealed by the 1999 Gramm-Leach-Bliley Act) prohibiting combining commercial banking with investment banking or insurance underwriting. Also, reduce their size by placing limits on banks’ assets or deposits. However, Emmons said this proposal likely wouldn’t succeed because combining commercial and investment banking was not the main source of problems; in fact, many of the “too-big-to-fail” institutions that caused problems during the crisis would have been allowed to operate under Glass-Steagall.
  • Create “narrow banks” – Separate payments functions from all other financial activities. Such a bank would take deposits and make payments but not make loans except those that have very little default risk. Emmons said this proposal wouldn’t be successful either because such banks are not likely to be viable. Narrow banks likely would seek to make riskier loans to improve their profitability, while non-narrow banks would seek to enter the payments business in one way or another.

“In fact, we have chosen not to pursue radical approaches to solving the ‘too-big-to-fail’ problem,” he said. “Instead, we’re implementing incremental—albeit significant—reforms of the existing legal, regulatory and governance frameworks in which banks operate.” Meanwhile, bankers, regulators and legislators won’t know whether the regulatory reform efforts will actually work until they are actually used. Those efforts, which have sparked a lot of profound debate throughout the financial industry, include:

  • The 2010 Dodd-Frank Act – The law includes living wills for orderly dissolution, capital requirements, stress tests, risk-based assessments on deposit insurance, FDIC orderly liquidation authority, the Volcker Rule and investor protections. “These are all pushing banks to be more effective in internal discipline,” Emmons said.
  • Basel III Accord – The third round of the Basel Accords is looking to improve the quality of bank capital and make other changes related to capital so that big banks demonstrate that they “have more skin in the game,” Emmons said.

Emmons also offered another proposal: Make a strictly enforced “death penalty” regime, a law mandating that any bank requiring government assistance would be nationalized, with a plan to sell it back to new shareholders at some point in the future. “The crux of the matter would be carrying through this pledge to re-privatize the institution,” he said. “It should reduce the incentives to take risk because the ‘death penalty’ is such a severe penalty that it would act as a deterrent.” Emmons noted that TARP (the Troubled Asset Relief Program) was a half-step in this direction, in which the federal government took noncontrolling equity positions in megabanks—preferred instead of common equity—and didn’t wipe out shareholders or management.

“It’s not so radical of a proposal because we did impose a ‘death penalty’ on Fannie Mae and Freddie Mac: Their shareholders and management were wiped out. General Motors and Chrysler were forced into bankruptcy, and AIG was effectively nationalized,” he said.

“If this were to be the plan, we would need (to continue the metaphor) an undertaker standing by—an institution that would be ready to exact this discipline on the firms,” he said, pointing to other nations’ permanent “sovereign wealth funds” that can take equity positions in firms.

The Jury Is Still Out

While investigations and lawsuits continue, regulations are written for new laws, and the industry wrestles with proposed capital and other standards, the question remains: Will any of this solve “too big to fail,” successfully rein in systemic risk or prevent future “misbehaviors”? Simply put, we don’t know yet.

“I think it’s really important to realize that these are the early days in terms of the reform efforts for the financial system, and many firms still have to navigate a pretty complex set of changes to the regulatory landscape, how the world is unfolding and how they’re going to generate profits,” Manzari said during the Q&A portion.

Stackhouse noted that of the 400 or so regulations and rules required by the Dodd-Frank Act, only about one-third are actually in place. “The financial community, large banks in particular—those with over $50 billion in assets—have a lot ahead of them,” she said. “The Dodd-Frank Act right now is the mechanism on the table to deal with these very large firms. The jury is still out on how that particular rule making will take place and how effective it will be.”

A strictly enforced "death penalty" sounds good to me, but I'd also like to reduce the ability of large financial institutions to influence politicians and regulators. The discussion does note that:

The revelations of recent controversies such as robo-signing, the London Whale and Libor rate-rigging—explored in the “Big Bank Misbehaviors” sidebar at the bottom—as well as other problems not mentioned here indicate that something critical was lacking in the discipline of large, complex banks.

But the regulatory capture aspect of large banks isn't addressed.

I mostly wanted to highlight this slide from the presentation because it answers a question I've been asking for a long time, how big do banks need to be in order to reach the minimum efficient scale?

And from another slide, the size of the largest banks:

Some summary measures:

The conclusion seems obvious to me.

Friday, February 22, 2013

'Big Health Insurance Rate Hikes are Plummeting'

Some evidence that Obamacare is reducing the rate of increase in the cost of health insurance:

Big health insurance rate hikes are plummeting, by Sarah Kliff: The number of double-digit rate increases requested by health insurers has plummeted over the past four years, according to a Friday report from the Obama administration.
Researchers combed through data available from the 15 states that publicly post all requests for rate increases in the individual market. They found that, in 2009, 74 percent of all requests came in above 10 percent. By 2012, that number had fallen to 35 percent. Preliminary data for 2013, which only cover a handful of states, shows 14 percent of rate increases asking for a double-digit bump. Here’s what this looks like in chart form:

rate increases

Does Obamacare get credit? The administration thinks so...
One other possible explanation: Over this time period, there has also been a big slowdown in the rate of health care cost growth. That began in 2009, so it’s not completely impossible that the health insurance industry, noticing that trend, began pricing individual market products at lower rates.
The administration has considered that idea though and looked at the large group market to test it. If the health cost slowdown really was driving lower premiums, the thinking went, it would show up across all insurance products. It didn’t...

Speaking of Obamacare, from Brad DeLong: Douglas Holtz-Eakin and Avik Roy: "You Know All That Stuff We Have Been Saying for Four Years? Nevermind!", and from Paul Krugman: More Swiss Myths.

Monday, February 18, 2013

The Minimum Wage and Employment when Employers Have Market Power

Richard Green:

Where's the monopsony?: President Obama, Paul Krugman and Robert Reich have all been pushing for an increase in the minimum wage. I want to agree with them, and Krugman is certainly correct that the preponderance of empirical evidence shows that the minimum wage's impact on total employment is negligible.
But the question is, why? Krugman's statement that human beings are not Manhattan apartments is true, and allows him to support the minimum wage while being appropriately skeptical of rent control, but it doesn't give a satisfactory answer as to why putting a floor on the price of labor would not create excess supply of labor.
There is in economic theory a set of circumstances, however, under which an increase in the minimum wage might raise employment. If an employer has a market largely to itself--if it has monopsony power--then it will both pay its workers less than their productivity warrants and not hire enough workers to be at the most efficient level of employment. Raising the minimum wage would then both increase pay and induce more workers into the labor market, hence increasing employment. If government could nail the minimum wage to the marginal revenue product of the least productive workers, the minimum wage could produce a first-best outcome--one where pay and employment levels were efficient.
For the argument to work, the demand for labor needn't be perfectly monopsonistic, but rather less than perfectly competitive. The fact that wages and labor productivity seem to have less and less to do with each other is evidence that the demand for labor is not competitive, but it would be nice to have further, detailed evidence of the industrial organization of labor demand.

David Card agrees with the monopsony perspective. Here is part of an interview of him (from 2006) by Douglas Clement of the Minneapolis Fed where he discusses this issue (in particular, see the part about "each employer has a tiny bit of monopoly power over his or her workforce," his comments on advocacy are also interesting):

Minimum Wage
Region: Your research on the effects of raising the minimum wage, much of which was compiled in your book with Alan Krueger, generated considerable controversy for its conclusion that raising the minimum wage would have a minor impact on employment.
Have you continued to conduct research on the impact of raising the minimum wage? And do you have an opinion about "living wage" legislation and the petition that's been circulated recently with 650 or so economists calling for an increase in the minimum wage?
Card: I haven't really done much since the mid-'90s on this topic. There are a number of reasons for that that we can go into. I think my research is mischaracterized both by people who propose raising the minimum wage and by people who are opposed to it. What we were trying to do in our research was use the minimum wage as a lever to gain more understanding of how labor markets actually work and, in particular, to address a question that we thought was quite important: To what extent does the simplest model of supply and demand actually describe how employers operate in the labor market? That model says that if an employer wants to hire another worker, he or she can hire as many people as needed at the going wage. Also, workers move freely between firms and, as a result, individual employers have no discretion in the wages that they offer.
In contrast to that highly simplified theoretical model, there is a huge literature that has evolved in labor economics over the last 25 years, arguing that individuals have to spend time looking for job opportunities and employers have to spend time finding employees. In this alternative paradigm a range of wage offers co-exist in the market at any one time. That broader theory is, I think, pretty widely accepted in most branches of economics. The same idea is used to think about product markets where two firms that sell very similar products may not charge exactly the same price. The theory explains a lot of things that don't seem to make sense, at least to me, in a simple demand and supply model.
For example, what does it mean for a firm to have a vacancy? If a firm can readily go to the market and buy a worker, there's no such thing as a vacancy, or at least not a persistent vacancy. During the early 1990s, when Alan and I were working on minimum wages, it was our perception that many low-wage employers had had vacancies for months on end. Actually many fast-food restaurants had policies that said, "Bring in a friend, get him to work for us for a week or two and we'll pay you a $100 bonus." These policies raised the question to us: Why not just increase the wage?
From the perspective of a search paradigm, these policies make sense, but they also mean that each employer has a tiny bit of monopoly power over his or her workforce. As a result, if you raise the minimum wage a little—not a huge amount, but a little—you won't necessarily cause a big employment reduction. In some cases you could get an employment increase.
I believe that that model of the labor market is correct. There are frictions in the market and some imperfect information. It doesn't mean that if we raised the minimum wage to $20 an hour we wouldn't have massive problems, if we enforced it. Realistically, of course, the U.S. is never going to enforce a draconian minimum wage, nor is one ever going to be passed. However, our results don't mean that minimum wages in other economies couldn't have some effect.
I think economists who objected to our work were upset by the thought that we were giving free rein to people who wanted to set wages everywhere at any possible level. And that wasn't at all the spirit of what we actually said. In fact, nowhere in the book or in other writing did I ever propose raising the minimum wage. I try to stay out of political arguments.
I think many people are concerned that much of the research they see is biased and has a specific agenda in mind. Some of that concern arises because of the open-ended nature of economic research. To get results, people often have to make assumptions or tweak the data a little bit here or there, and if somebody has an agenda, they can inevitably push the results in one direction or another. Given that, I think that people have a legitimate concern about researchers who are essentially conducting advocacy work. I try to stay away from advocacy of any kind, but that doesn't prevent people from being suspicious that I have an agenda of some kind.
I've subsequently stayed away from the minimum wage literature for a number of reasons. First, it cost me a lot of friends. People that I had known for many years, for instance, some of the ones I met at my first job at the University of Chicago, became very angry or disappointed. They thought that in publishing our work we were being traitors to the cause of economics as a whole.
I also thought it was a good idea to move on and let others pursue the work in this area. You don't want to get stuck in a position where you're essentially defending your old research. I certainly think it's possible that someone will come up with credible research documenting a situation where raising the minimum wage has a significant employment effect. I rather doubt we will see that right now because minimum wages are fairly low, at least in northern California where I live. My guess is that small raises in the minimum wage won't have much of an effect.
I think the monopsony power argument is correct (an argument I made in a job market paper long, long ago in trying to explain the correlation between wages and productivity).

Friday, February 15, 2013

Does Raising the Minimum Wage Really Help Workers?

I have some comments on the minimum wage at MoneyWatch:

Does raising the minimum wage really help workers?

One of the questions I address is whether it would be better to increase the EITC instead of increasing the minimum wage.

Thursday, February 14, 2013

Rebuttal to Study on SF Plastic-bag Ban and Foodborne-illness

Here is a rebuttal to something I posted not too long ago on potential harm from banning plastic bags (via Tim Taylor):

San Francisco plastic-bag ban associated with 46% increase in foodborne-illness deaths — Not!

The post at The Berkeley Blog is not very informative -- I'd recommend clicking through to the actual response:

My full memo is here: SF-Health-Officer-MEMO-re-Reusable-Bag-Study_V8-FIN
The Klick study I read is here: SSRN-id2196481

Monday, February 11, 2013

'Why Has Employment Remained Stubbornly Low?'

Remember the debate about whether the slow recovery was due to lack of demand, regulation, or taxes?:

Aggregate Demand and State-Level Employment, by Atif Mian and Amir Sufi, FRBSF Economic Letter: What explains the sharp decline in U.S. employment from 2007 to 2009? Why has employment remained stubbornly low? Survey data from the National Federation of Independent Businesses show that the decline in state-level employment is strongly correlated with the increase in the percentage of businesses complaining about lack of demand. While business concerns about government regulation and taxes also rose steadily from 2008 to 2011, there is no evidence that job losses were larger in states where businesses were more worried about these factors. ...

Thursday, February 07, 2013

'Reusable Grocery Bags Can Kill (Unless Washed)'

A plastic bag ban is going to go into effect here in Eugene, Oregon on May 1:

Reusable Grocery Bags Can Kill (Unless Washed), by Tim Taylor: One recent local environmental cause, especially popular in California, has been to ban or tax plastic grocery bags. The expressed hope is that shoppers will instead carry reusable grocery bags back and forth to the grocery store, and that plastic bags will be less likely to end up in landfills, or blowing across hillsides, or floating in water. The problem is that almost no one ever washes their reusable grocery bags. Reusuable grocery bags often carry raw meat, unseparated from other foods, and are often stored for convenience in the trunk of cars that sit outside in the sun. In short, reusuable grocery bags can be a friendly breeding environment for E. coli bacteria, which can cause severe illness and even death.

Jonathan Klick and Joshua D. Wright tell this story in "Grocery Bag Bans and Foodborne Illness," published as a research paper by the Institute for Law and Economics at the University of Pennsylvania Law School. As their primary example, they look at E. coli infections in the San Francisco County after it adopted an ordinance severely limiting the use of plastic bags by grocery stores.

As one piece of evidence, here's a figure showing the number of emergency room visits in San Francisco County related to E. coli for the 10 quarters before and after the enactment of the ordinance, where zero on the horizontal axis is the date the ordinance went into effect. (The shaded area around the line is a 95% statistical confidence interval.)  Clearly, there is a discontinuous jump in the number of emergency room visits.
For comparison, here's the same measure of emergency room visits related to E. coli infections for the other counties in the San Francisco Bay Area in the 10 quarters before and after the ordinance was enacted. These counties don't see a jump.
Klick and Wright flesh out this finding in a variety of ways. ... Overall, they find that San Francisco typically experiences about 12 deaths per year from intestinal infections, and that the restrictions on plastic bags probably let to another 5-6 deaths per year in that city--plus, of course, the personal and social costs of some dozens of additional hospitalizations. With these costs taken into account, restrictions on plastic bags stop looking like a good idea.

Of course, a possible response to this problem is to launch a public information campaign to encourage people to wash their reusable grocery bags. But that response then leads to two other issues.  First, if public information campaigns can be effective on the grocery bag issue, the campaign could simply focus on the need to dispose of plastic bags properly and recycle them where possible--without a need to ban them. The argument for an ordinance sharply limiting the use of plastic grocery bags is, in effect, based on an implicit assumption that public information campaigns about grocery bags don't work well.  Second, if reusable grocery bags are washed after each use, then any cost-benefit analysis of their use would have to take into account the costs of water and detergent use. I have no idea if these costs alone would outweigh the benefits of reusable grocery bags, but it might be a near thing. 

 Like most economists, I have a mental file drawer of "good intentions aren't enough" stories. The push to ban plastic grocery bags is one more example.

Tuesday, February 05, 2013

The Case For and Against Too-Big-to-Fail Banks

I've been asking for some time now what amounts to a simple question, "What is the minimum efficient scale for financial institutions?" Unfortunately, the answer is much harder to formulate than the question, and there hasn't been anything convincing (at least to me) on this topic. Here's the latest on this topic from Neil Irwin:

The case for the too-big-to-fail banks, by Neil Irwin: ...[I]n the last few months, there's been a new wave of calls to break up the "too big to fail" banks that were at the center of the crisis — and the beneficiaries of a massive wave of bailouts.
So, is splitting those banks up the answer? ... The move ... has a growing list of powerful allies. ... But what is the counterargument? ... A new paper from Patrick Sims of Hamilton Place Strategies, a policy and communications firm led by Bush administration White House and Treasury official Tony Fratto, amounts to a case for the big banks. (Hamilton Place counts major banks and their trade associations among its clients)..., here are some of the arguments that I believe have the most merit.
The first argument is also the simplest. This is a huge and complex global economy. With trillions of dollars in global trade and companies with hundreds of billions in assets, it takes giant banks with a global reach to supply them with the financial products they need to do business. ...
This is related to a second line of argument: That without huge, regulated banks, companies will turn to the unregulated "shadow banking" sector to meet their financial needs... The collapse of the shadow banking system was a crucial factor in the 2008 crisis... If a bank break-up sparked a vast expansion of shadow banking, it would make the financial system more vulnerable.
I find less persuasive Sims's argument that we shouldn't worry too much about concentration in the banking system because it's not quite as severe in the United States as in other countries. One of the paper's tables notes that the largest U.S. bank, JPMorgan Chase, has assets that amount to 15 percent of U.S. GDP...
As the too-big-to-fail debate heats up, these are the questions... What real value do megabanks create for the world? Do they need to be this huge to fulfill their roles? Can regulation be enough to tame their inherent risks, or do they need to be split up? ...

Here are some past posts on this topic. This was a response to a speech by William Dudley on the too big to fail problem (November, 2012):

Solving the Too Big to Fail Problem: ...One thing we really need to understand better is the minimum efficient scale for various financial activities. Whenever the topic of breaking banks into smaller pieces is raised, we hear that a "much reduced size threshold could sacrifice socially useful economies of scale and scope benefits." The key word is "could." As far as I can tell, the evidence on this point is very shaky -- we just don't know for sure what size is necessary to exploit efficiencies. My own view is that the minimum scale is likely smaller than many firms today, and hence there would be no harm in reducing firms size. This may not help much with stability, but there are still perhaps many benefits (e.g. reduced political and economic power) from reducing firm size and increasing the number of institutions engaged in important financial activities.

A response to Tyler Cowen's alternative to breaking up big banks (February, 2012):

Break Up the Banks? Here’s an Alternative: ... 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. ...
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). ...
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 regulations are in the works, but for now the problem has not yet been resolved.

And a response to Bernanke's "smaller banks are not necessarily the answer" (October, 2009):

Bernanke: Smaller Banks Not Necessarily the Answer: ... Ben Bernanke does not want to lose "the economic benefit of multi-function, international (financial) firms," so he is hesitant to break large banks into smaller sized institutions. I don't have much problem with the economics, if there are efficiencies that come with bank size we should exploit them, especially if breaking up banks into smaller entities does little to reduce systemic risk but instead simply fragments the problem into many more pieces (though I'd still like to know where the minimum efficient scale is, anything larger than that is unnecessary). Obtaining resolution authority for banks in the shadow system is also very important, so I don't disagree with the emphasis on this in Bernanke's remarks.
But there seems to be the view that if they have resolution authority, higher capital requirements, etc., that will make the probability of a major breakdown small enough so that the expected benefits of size outweigh the expected costs. While I agree that obtaining resolution authority and other regulatory change is extremely important, I wouldn't bet my house, or housing and asset markets more generally, that this will eliminate the chance of a major breakdown, or make the chance small enough to justify huge, powerful, market-dominating institutions.
I would like to see more effort to measure and regulate connectedness within the system (which can be very high even with banks broken into smaller pieces) since that would add another layer of protection, the degree of leverage should come under scrutiny as well, and I would also like to see more attention to the political risks (e.g. capture of legislators and hence regulation) posed by large financial firms

Finally, A response to David Altig (this is the entire post from April, 2009):

Breaking Up Big Banks: As Usual, Benefits Come with a Side of Costs: David Altig warns that breaking up big banks could reduce efficiency:

Breaking up big banks: As usual, benefits come with a side of costs, by David Altig. macroblog: Probably the least controversial proposition among an otherwise very controversial set of propositions on which financial reform proposals are based is that institutions deemed "too big to fail" (TBTF) are a real problem. As Fed Chairman Bernanke declared not too long ago:

As the crisis has shown, one of the greatest threats to the diversity and efficiency of our financial system is the pernicious problem of financial institutions that are deemed "too big to fail."

The next question, of course, is how to deal with that threat. At this point the debate gets contentious. One popular suggestion for dealing with the TBTF problem is to just make sure that no bank is "too big." Two scholars leading that charge are Simon Johnson and
James Kwak (who are among other things the proprietors at The Baseline Scenario blog). They make their case in the New York Times' Economix feature:

Since last fall, many leading central bankers including Mervyn King, Paul Volcker, Richard Fisher and Thomas Hoenig have come out in favor of either breaking up large banks or constraining their activities in ways that reduce taxpayers' exposure to potential failures. Senators Bernard Sanders and Ted Kaufman have also called for cutting large banks down to a size where they no longer pose a systemic threat to the financial system and the economy.

…We think that increased capital requirements are an important and valuable step toward ensuring a safer financial system. We just don't think they are enough. Nor are they the central issue…

We think the better solution is the "dumber" one: avoid having banks that are too big (or too complex) to fail in the first place.

Paul Krugman has noted one big potential problem with this line of attack:

As I argued in my last column, while the problem of "too big to fail" has gotten most of the attention—and while big banks deserve all the opprobrium they're getting—the core problem with our financial system isn't the size of the largest financial institutions. It is, instead, the fact that the current system doesn't limit risky behavior by "shadow banks," institutions—like Lehman Brothers—that carry out banking functions, that are perfectly capable of creating a banking crisis, but, because they issue debt rather than taking deposits, face minimal oversight.

In addition to that observation—which is the basis of calls for a systemic regulator that spans the financial system, and not just specific classes of financial institutions—there is another, very basic, economic question: Why are banks big?

To that question, there seems to be an answer: We have big banks because there are efficiencies associated with getting bigger—economies of scale. David Wheelock and Paul Wilson, of the Federal Reserve Bank of St. Louis and Clemson University, respectively, sum up what they and other economists know about economies of scale in banking:

…our findings are consistent with other recent studies that find evidence of significant scale economies for large bank holding companies, as well as with the view that industry consolidation has been driven, at least in part, by scale economies. Further, our results have implications for policies intended to limit the size of banks to ensure competitive markets, to reduce the number of banks deemed "too-big-to-fail," or for other purposes. Although there may be benefits to imposing limits on the size of banks, our research points out potential costs of such intervention.

Writing at the National Review Online, the Cato Institute's Arnold Kling acknowledges the efficiency angle, and then dismisses it:

There's a long debate to be had about the maximum size to which a bank should be allowed to grow, and about how to go about breaking up banks that become too large. But I want to focus instead on the general objections to large banks.

The question can be examined from three perspectives. First, how much economic efficiency would be sacrificed by limiting the size of financial institutions? Second, how would such a policy affect systemic risk? Third, what would be the political economy of limiting banks' size?

It is the political economy that most concerns me…

If we had a free market in banking, very large banks would constitute evidence that there are commensurate economies of scale in the industry. But the reality is that our present large financial institutions probably owe their scale more to government policy than to economic advantages associated with their vast size.

I added the emphasis to the "probably" qualifier.

The Wheelock-Wilson evidence does not disprove the Kling assertion, as the estimates of scale economies are obtained using banks' cost structures, which certainly are impacted by the nature of government policy. But if economies of scale are in some way intrinsic to at least some aspects of banking—and not just political economy artifacts—the costs of placing restrictions on bank size could introduce risks that go beyond reducing the efficiency of the targeted financial institutions. If some banks are large for good economic reasons, the forces that move them to become big would likely emerge with force in the shadow banking system, exacerbating the very problem noted by Krugman.

I think it bears noting that the argument for something like constraining the size of particular banks implicitly assumes that it is not possible, for reasons that are either technical or political, to actually let failing large institutions fail. Maybe it is so, as Robert Reich asserts in a Huffington Post item today. And maybe it is in fact the case that big is not beautiful when it comes to financial institutions. But in evaluating the benefits of busting up the big guys, we shouldn't lose sight of the possibility that this is also a strategy that could carry very real costs.

I'd like to know the source of the scale economies. The paper linked above estimates returns to scale, but not their source. As noted in the introduction (and also noted by David):

Our results indicate that as recently as 2006 banks faced increasing returns to scale, suggesting that scale economies are a plausible (though not necessarily only) reason for the growth in bank size...

Without knowing the source of the changes in costs as banks increase in size, the (non-parametric) results -- results that differ from most previous work -- are hard to evaluate. I've been hoping for good estimates of the size and nature of the economies of scale for banks, but I'm not fully convinced by this evidence.

One final note. Even if the scale economies are there, we may still want to restrict the size of banks. The benefit from larger scale must be balanced against the increased risk to the financial system and the increased risk of political/regulator capture that comes with size and power. If the costs of size outweigh the benefits, then size should be restricted below the minimum efficient scale (How much risk comes with size depends, in large part, upon your faith in resolution authority discussed above. I am not fully convinced it will work.)

Monday, February 04, 2013

Securitization Lead to Riskier Corporate Lending

João Santos, vice president in the Research and Statistics Group of the Federal Reserve Bank of New York:

Did Securitization Lead to Riskier Corporate Lending?, by João Santos: There’s ample evidence that securitization led mortgage lenders to take more risk, thereby contributing to a large increase in mortgage delinquencies during the financial crisis. In this post, I discuss evidence from a recent research study I undertook with Vitaly Bord suggesting that securitization also led to riskier corporate lending. We show that during the boom years of securitization, corporate loans that banks securitized at loan origination underperformed similar, unsecuritized loans originated by the same banks. Additionally, we report evidence suggesting that the performance gap reflects looser underwriting standards applied by banks to loans they securitize. ...
Our evidence that securitization led to riskier corporate lending is in line with similar findings unveiled by studies of the effects of securitization on mortgage lending. Taken together, these studies confirm an important downside of securitization.

Paul Krugman: Friends of Fraud

Will Senate Republicans be able to kill, or at least defang, the Consumer Financial Protection Bureau?:

Friends of Fraud, by Paul Krugman, Commentary, NY Times: Like many advocates of financial reform, I was a bit disappointed in the bill that finally emerged. Dodd-Frank gave regulators the power to rein in many financial excesses; but ... the financial industry’s wealth and influence can all too easily turn those who are supposed to serve as watchdogs into lap dogs instead.
There was, however, one piece of the reform that was a shining example of how to do it right: the creation of a Consumer Financial Protection Bureau... And sure enough, Senate Republicans are going all out in an attempt to kill that bureau. ...
Now, you might be tempted to say that while we need protection against financial fraud, there’s no need to create another bureaucracy. Why not leave it up to the regulators we already have? The answer is that existing regulatory agencies are basically concerned with bolstering the banks; as a practical, cultural matter they will always put consumer protection on the back burner...
So the consumer protection bureau serves a vital function. But as I said, Senate Republicans are trying to kill it. ...
What Republicans are demanding, basically, is that the protection bureau lose its independence. They want its actions subjected to a veto by other, bank-centered financial regulators, ensuring that consumers will once again be neglected, and they also want to take away its guaranteed funding, opening it to interest-group pressure. These changes would make the agency more or less worthless — but that, of course, is the point. ...
And as always, you should follow the money. Historically, the financial sector has given a lot of money to both parties, with only a modest Republican lean. In the last election, however, it went all in for Republicans, giving them more than twice as much as it gave to Democrats (and favoring Mitt Romney over the president almost three to one). All this money wasn’t enough to buy an election — but it was, arguably, enough to buy a major political party.
Right now, all the media focus is on the obvious hot issues — immigration, guns, the sequester, and so on. But let’s try not to let this one fall through the cracks: just four years after runaway bankers brought the world economy to its knees, Senate Republicans are using every means at their disposal, violating all the usual norms of politics in the process, in an attempt to give the bankers a chance to do it all over again.

Friday, February 01, 2013

'Blame Bangladesh, Not the Brands'

Jagdish Bhagwati answers the following question:

Recent factory fires in Pakistan and Bangladesh have killed more than 400 people. Yet, the stricken garment manufacturers had apparently passed inspection — despite bars on windows and locked exits — and been deemed safe.

These factories supply clothing to — and are in business because of — American companies like Wal-Mart and Sears. So where does the responsibility lie in improving worker safety, and what can be done about it?

Here's his response:

Blame Bangladesh, Not the Brands, by Jagdish Bhagwati: The community was in a “palpable state of shock” over the fire at a plant that left 25 workers dead and 55 others injured. “Many people who lost loved ones and friends in the fire expressed bitterness... They acknowledged that the plant provided significant employment..., but they were deeply concerned by reports that many of the victims ... were trapped in the building by blocked exits.”
Was this a report from Bangladesh or Karachi? No, it was from a poultry processing plant in Hamlet, N.C. ... in 1991. Blame for that fire was cast not just on the company, but on the government.
The Bangladesh fires emphasize again a lax and lackadaisical attitude to the issue of workplace safety by the Bangladeshi authorities, possibly aided and abetted by domestic politics. This reflects a general attitude of neglect in protecting workers against unsafe conditions, like providing goggles and ensuring that they are worn when workers operate close to an open furnace.
But asking Wal-Mart, Gap and other brands to substitute for the somnolent government will only marginally address worker safety reform. What is necessary is for the Bangladeshi government to stop resting on its laurels of social progress — a myth, which I and the economist Arvind Panagariya have recently challenged, and step up to the plate to establish proper regulations and monitoring, extending to all of Bangladesh, not just its garment factories.

I agree that the Bangladeshi government should "step up to the plate to establish proper regulations and monitoring," but companies have a role to play too (they may, for example, have political power that can be used to block or encourage regulation and monitoring, and there is the moral obligation to protect workers as well). If we assume the companies can't do much, and don't hold them accountable -- if we brush it off as an inevitable response to market pressures in an environment with few constraints on this type of behavior -- they'll have no incentive to change.

Wednesday, January 30, 2013

'The Real, and Simple, Equation That Killed Wall Street'

I'm sympathetic to the argument that excess leverage was a problem in the financial crisis, but I don't see it the primal cause of the recession. Instead, leverage iss a magnifier that makes things much, much worse when problems occur:

The Real, and Simple, Equation That Killed Wall Street, by Chris Arnade, Scientific American: ...It ... is the overly simple narrative that many in the media have spun about the last financial crisis. Smart meddling kids armed with math hoodwinked us all.
One article, from the March 2009 Wired magazine, even pinpointed an equation and a mathematician. The article “Recipe for Disaster: The Formula That Killed Wall Street,” accused the Gaussian Copula Function.
It was not the first piece that made this type of argument, but it was the most aggressive. ...
This theme plays on the fallacy that danger always comes from complexity. ...
The reality is much simpler and less sexy. Wall Street killed itself in a time-honored fashion: Cheap money, excessive borrowing, and greed. And yes, there is an equation one can point to and blame. This equation, however, requires nothing more than middle school algebra to understand and is taught to every new Wall Street employee. It is leveraged return. ...
The Gaussian Copula Function, opaque to most, is convenient to blame. It allows us to shake off our collective sense of guilt. It obscures the real crime...

I'm willing to blame leverage for contributing to the magnitude of the crisis, and I've long-called for limits on leverage to mute the negative effects of the next financial recession, which will come no matter how hard we try to avoid it. But I don't think it's correct to blame leverage itself for our problems, i.e. that "there is an equation one can point to and blame."

[The article actually notes many other factors, e.g. bad incentives for ratings agencies, failures of regulation, easy moneary policy by the Fed, and so on, but still ends up focusing on the leverage component as the key factor. In any case, the article is directed squarely at Felix Salmon, and I'm posting this in the hope that it will help prod him into responding.]

Tuesday, January 22, 2013

Time Is Not On Our Side

What if we actually achieve the target of limiting global warming to a 2 degree Celsius increase? We are unlikely to meet this goal -- it's looking much worse than that -- but what if we did?:

 ... It is abundantly clear that the target of a 2-degree Celsius limit to climate change was mostly derived from what seemed convenient and doable without any reference to what it really means environmentally. Two degrees is actually too much for ecosystems. Tropical coral reefs are extremely vulnerable to even brief periods of warming. .. A 2-degree world will be one without coral reefs (on which millions of human beings depend for their well-being)..., there undoubtedly will be massive extinctions and widespread ecosystem collapse. The difficulty of trying to buffer and manage change will increase exponentially with only small increments of warming.
In addition, the last time the planet was 2 degrees warmer, the oceans were four to six (perhaps eight) meters higher. We may not know how fast that will happen (although it is already occurring more rapidly than initially estimated), but the end point in sea-level rise is not in question. A major portion of humanity lives in coastal areas and small island states that will go under water. ...
More than a 2-degree increase should be unimaginable. Yet to stop at 2 degrees, global emissions have to peak in 2016. ...
Environmental change is happening rapidly and exponentially. We are out of time.

Of course, global emissions won't be anywhere near a peak in 2016.

Monday, January 21, 2013

Paul Krugman: The Big Deal

Progressives should cheer up:

The Big Deal, by Paul Krugman, Commentary, NY Times: On the day President Obama signed the Affordable Care Act into law, an exuberant Vice President Biden famously pronounced the reform a “big something deal” — except that he didn’t use the word “something.” And he was right..., if progressives look at where we are as the second term begins, they’ll find grounds for a lot of (qualified) satisfaction.

Consider, in particular, three areas: health care, inequality and financial reform.

Health reform is, as Mr. Biden suggested, the centerpiece of the Big Deal. Progressives have been trying to get some form of universal health insurance since the days of Harry Truman; they’ve finally succeeded. …

What about inequality? ... Like F.D.R., Mr. Obama took office in a nation marked by huge disparities in income and wealth. But where the New Deal had a revolutionary impact, empowering workers and creating a middle-class society that lasted for 40 years, the Big Deal has been limited to equalizing policies at the margin.

That said,... through new taxes ... 1-percenters will see their after-tax income fall around 6 percent... This will reverse only a fraction of the huge upward redistribution that has taken place since 1980, but it’s not trivial.

Finally, there’s financial reform. The Dodd-Frank reform bill is ... not the kind of dramatic regime change one might have hoped for… Still, if plutocratic rage is any indication, the reform isn’t as toothless as all that. …

All in all, then, the Big Deal has been, well, a pretty big deal. But will its achievements last? ... I ... think so. For one thing, the Big Deal’s main policy initiatives are already law. ... And ... the Big Deal agenda is, in fact, fairly popular — and will become more popular once Obamacare goes into effect...

Finally, progressives have the demographic and cultural wind at their backs. Right-wingers flourished for decades by exploiting racial and social divisions — but that strategy has now turned against them...

Now, none of what I’ve just said should be taken as grounds for progressive complacency. The plutocrats may have lost a round, but their wealth and the influence it gives them in a money-driven political system remain. Meanwhile, the deficit scolds (largely financed by those same plutocrats) are still trying to bully Mr. Obama into slashing social programs. ...

Still, maybe progressives — an ever-worried group — might want to take a brief break from anxiety and savor their real, if limited, victories.

Saturday, January 19, 2013

Financial Collapse: A 10-Step Prevention Plan

Alan Blinder lists "10 financial commandments, all of which were brazenly violated in the years leading up to the crisis":

Financial Collapse: A 10-Step Recovery Plan, by Alan S. Blinder: ...let me try to encapsulate what we must remember about the financial crisis...:
1. Remember That People Forget ...
2. Do Not Rely on Self-Regulation ...
3. Honor Thy Shareholders ...
4. Elevate Risk Management ...
5. Use Less Leverage ...
6. Keep It Simple, Stupid ...
7. Standardize Derivatives and Trade Them on Exchanges ...
8. Keep Things on the Balance Sheet ...
9. Fix Perverse Compensation ...
10. Watch Out for Consumers ...
Mark Twain is said to have quipped that while history doesn’t repeat itself, it does rhyme. There will be financial crises in the future, and the next one won’t be a carbon copy of the last. Neither, however, will it be so different that these commandments won’t apply. ...

Friday, January 18, 2013

'Health Care Rationing Is Nothing New'

On health care rationing in the US:

Health Care Rationing Is Nothing New [Excerpt], by Beatrix Hoffman: ... Opponents of the 2010 Patient Protection and Affordable Care Act warn that the new health care law will lead to rationing, or limits on medical services. But many observers point out that health care is already rationed in the United States. "We've done it for years," said Dr. Arthur Kellermann, professor of emergency medicine and associate dean for health policy at Emory University School of Medicine. "In this country, we mainly ration on the ability to pay." ...
Countries with universal health systems ration health care via controlled distribution, whether through national budgeting, government setting of prices and provider fees, restrictions on some services, or a combination of methods. The United States health care system rations primarily by price and insurance coverage—and ... many other methods as well. Americans have learned to fear European or Canadian types of rationing, but don't see that the United States practices both price rationing and other types of rationing in health care.
Rationing in the United States is ... practiced by government agencies, private health insurance companies, hospitals, and providers, in ways both official and unofficial, intended and unintended, visible and invisible. The American way of rationing is a complex, fragmented, and often contradictory blend of policies and practices, unique to the United States. ... Health care has been rationed by race, in the case of the Jim Crow health system and other types of racial discrimination; by region, in the case of the uneven distribution of health facilities and personnel throughout the country; by employment and occupation, in the case of the job-based health insurance system; by address, in the case of residency requirements for various kinds of health care; by type of insurance coverage, in the case of health insurance that limits benefits and choice of doctor and hospital; by parental status, in the case of Medicaid (childless individuals are often excluded); by age, in the case of Medicare and the State Children's Health Insurance Programs—and the list goes on. These types of health care organization ... have rarely been called rationing. ...

Wednesday, January 16, 2013

'The Right’s Resistance to Regulation'

Peter Dizikes of MIT News:
The right’s resistance to regulation, by Peter Dizikes, MIT News Office: James Watt, who served as Secretary of the Interior from 1981 to 1983, is remembered primarily for a short, business-friendly tenure that ended with his resignation soon after an ill-judged remark about women, minorities and the disabled. And yet, as MIT professor Judith Layzer observes in her new book about environmental politics, “Open for Business,” there is good reason to regard Watt’s impact differently.

For one thing, Watt, among others on the political right, managed to cut government funding for conservation efforts. For another, he installed staff members who emphasized the development of natural resources, rather than just the protection of land. In so doing, Watt was one of many Republicans who instituted fundamental changes in U.S. environmental policy.

“I will build an institutional memory that will be here for decades,” Watt once said of his department, as Layzer recounts.

These kinds of under-the-radar changes, Layzer argues, are one of two ways conservatives have dramatically altered environmental politics since the 1970s, when environmentalists probably reached the high point of their political influence.

The other, says Layzer, an associate professor of environmental policy at MIT, is ideological and rhetorical: Conservatives have gained enormous traction by touting “the virtues of the market system and the horrors of regulation,” thus limiting public backing for stricter government-imposed controls on natural resources. By arguing that the market economy, when left alone, is effectively self-policing and morally sound, conservatives have put environmentalists on the defensive, making them tentative about arguing for environmental protections as a good in themselves. So whereas President Richard Nixon once green-lighted the Environmental Protection Agency, today’s political debates often touch on the necessity of opening further federal lands for oil exploration.

“The set of conservative ideas has really pushed the framing of issues to the point where many people today aren’t even aware of the [older] alternatives,” Layzer says. “Only if you’d been involved or lived through this history would you know it hasn’t always been thus.” ...[continue]...

The one thing I'll note is that "free market rhetoric," which is said to have played a key role in winning (or at least shifting) the battle of ideas, was the vehicle for defending other interests, e.g. business interests in having as few environmental regulations as possible. It (free markets) was not the goal in and of itself.

As to what should be done, for this reason I'm not so sure that “It really was about ideas." And you have to fight ideas with ideas.” It was also about having the political power to make the ideas heard, and to turn them into actual legislation that served the interests of the of those supporting the politicians financially. So I'd say, "It was really about using ideas to serve the interests of those who held the reins of power." Or something like that.

Wednesday, January 09, 2013

The FTC and Google

Shane Greenstein:

The FTC and Google: What did Larry Learn?, by Shane Greenstein: The FTC and Google settled their differences last week, putting the final touches on an agreement. Commentators began carping from all sides as soon as the announcement came. The most biting criticisms have accused the FTC of going too easy on Google. Frankly, I think the commentators are only half right. Yes, it appears as if Google got off easy, but, IMHO, the FTC settled at about the right place.
More to the point, it is too soon to throw a harsh judgment at Google. This settlement might work just fine, and if it does, then society is better off than it would have been had some grandstanding prosecutor decided to go to trial.
Why? First, public confrontation is often a BIG expense for society. Second, as an organization Google is young and it occupies a market that also is young. The first big antitrust case for such a company in such a situation should substitute education for severe judgment.
Ah, this will take an explanation. ...

Wednesday, December 26, 2012

'A Conservative Case for the Welfare State'

Bruce Bartlett argues conservatives should support the welfare state:

A Conservative Case for the Welfare State, by Bruce Bartlett, Commentary, NY Times: At the root of much of the dispute between Democrats and Republicans over the so-called fiscal cliff is a deep disagreement over the welfare state. Republicans continue to fight a long-running war against Social Security, Medicare, Medicaid and many other social-welfare programs that most Americans support overwhelmingly and oppose cutting. ...
This is foolish and reactionary. Moreover, there are sound reasons why a conservative would support a welfare state. Historically, it has been conservatives like the 19th century chancellor of Germany, Otto von Bismarck, who established the welfare state in Europe. They did so because masses of poor people create social instability and become breeding grounds for radical movements.
In postwar Europe, conservative parties were the principal supporters of welfare-state policies in order to counter efforts by socialists and communists to abolish capitalism altogether. The welfare state was devised to shave off the rough edges of capitalism and make it sustainable. Indeed, the conservative icon Winston Churchill was among the founders of the British welfare state.
American conservatives, being far more libertarian than their continental counterparts, reject the welfare state for both moral and efficiency reasons. It creates unhappiness, they believe, and inevitably becomes bloated, undermining incentives and economic growth.
One problem with this conservative view is its lack of an empirical foundation. Research by Peter H. Lindert of the University of California, Davis, shows clearly that the welfare state is not incompatible with growth while providing a superior quality of life to many of those left to sink or swim in America. ...
There are many ... ways ... in which what the conservatives call bloated European welfare states are actually very efficient. ...
American conservatives routinely assert that the people of Europe live in virtual destitution because of their swollen welfare states. But according to a commonly accepted index of life satisfaction, many heavily taxed European countries rank well above the United States...

If conservatives want to support the welfare state out of the desire to defend capitalism from "socialists and communists" -- to defend it against the instability that high degrees of inequality cause -- no problem, though it's interesting that they would acknowledge that the system itself can lead to societal inequities that are so dangerous the government needs to intervene to fix them. I prefer the efficiency argument (which is not to say that the other argument has no merit, it does). When there are substantial market failures -- the type that exist in retirement and health markets for example -- the government can make these markets work better through rules, mandates, and other regulatory interventions, or it can provide the services itself. Whether a heavily regulated private market will work better than the government providing services itself in the presence of substantial market failures is something that can be debated, and in general the lines aren't always clear. But for health and retirement markets it does appear that direct government provision works better than heavily regulated markets (i.e. "privatization"). In any case, the broader point is that the government provision of social insurance either directly or indirectly can be justified on an efficiency argument, i.e. as a means of overcoming market failures that prevent the private sector from providing these important goods and services in sufficient quantities at the lowest possible price.

Friday, December 21, 2012

What Do Economists Know (about Guns)?

Stephen Williamson:

Guns, by Stephen Williamson: Like most of you, I've been thinking about guns for the last few days. As economists, what do we have to say about gun control? ...

What's the problem here? ... The people who buy the guns and use them seem to enjoy having them. But there are third parties who suffer. ...
There are also information problems. It may be difficult to determine who is a hunter, who is temporarily not in their right mind, and who wants to put a loaded weapon in the bedside table.

What do economists know? We know something about information problems, and we know something about mitigating externalities. Let's think first about the information problems. Here, we know that we can make some headway by regulating the market so that it becomes segmented, with these different types of people self-selecting. This one is pretty obvious, and is a standard part of the conversation. Guns for hunting do not need to be automatic or semi-automatic, they do not need to have large magazines, and they do not have to be small. If hunting weapons do not have these properties, who would want to buy them for other purposes?

On the externality problem, we can be more inventive. A standard tool for dealing with externalities is the Pigouvian tax..., the Pigouvian tax we would need to correct the externality should be a large one, and it could generate a lot of revenue. If there are 300 million guns in the United States, and we impose a tax of $3600 per gun on the current stock, we would eliminate the federal government deficit. But $3600 is coming nowhere close to the potential damage that a single weapon could cause. A potential solution would be to have a gun-purchaser post collateral - several million dollars in assets - that could be confiscated in the event that the gun resulted in injury or loss of life. This has the added benefit of mitigating the moral hazard problem - the collateral is lost whether the damage is "accidental" or caused by, for example, someone who steals the gun.

Of course, once we start thinking about the size of the tax (or collateral) needed to correct the inefficiency that exists here, we'll probably come to the conclusion that it is more efficient just to ban particular weapons and ammunition at the point of manufacture. I think our legislators should take that as far as it goes.

Sunday, December 09, 2012

'GOP Fires Author of Copyright Reform Paper'

This is pretty Mickey Mouse. Republicans have fired a staffer for daring to put market reform -- making markets work better like Republicans say they favor -- ahead of special interests.:

GOP fires author of copyright reform paper, by Cory Doctorow: Derek Khanna, the Republican House staffer who wrote an eminently sensible paper on copyright reform that was retracted less than a day later has been fired. So much for the GOP's drive to attract savvy, net-centric young voters. After all, this is the party that put SOPA's daddy in charge of the House Tech and Science Committee.
But it's pretty terrible for Khanna -- what a shabby way of dealing with dissent within your ranks.

From the linked article:

it's now been confirmed that, due to significant lobbying pressure by the entertainment industry and (even more so) the US Chamber of Commerce, Derek Khanna ... has been let go from his job.

Where's the outrage from sensible Republicans (I checked Mankiw, but he's whining about taxes on the wealthy again today -- big surprise there)? Saying Republicans support free markets is almost as funny as saying they want lower taxes on the wealthy because of the wondrous economic growth miracle lower taxes would bring us. (Can you feel that miracle all around us from the vastly lower taxes we already have? No? You must be in the wrong income class.) Republicans want what's good for the people who pay for their campaigns, nothing more, nothing less, and they'll use whatever arguments get them there.

Wednesday, December 05, 2012

A Counter Example to the 'Tragedy of the Commons'

Running late -- have a dissertation proposal defense to get to, then a final to give to my Ph.D. students -- so a quick one:

A Counter Example to the "Tragedy of the Commons", by Matthew Kahn: ...This OP-ED by Andrew Kahrl is actually quite interesting. ... For at least 20 years, I have lectured on the "tragedy of the commons" that takes place both in cities and in the oceans. Consider a smoker in a city...[numerical example]. This is a simple example of the tragedy of the commons --- this smoker unintentionally degraded the commons as he pursued his privately optimal action. The same logic applies to over-fishing in common oceans. One "solution" to this property rights issue is to privatize the commons and the owner would charge a price to allow the smoker to smoke and the smoker would only smoke if he is willing to pay this fee.

We can now evaluate Professor Kahrl's claims. He argues that the privatization of beaches in the Northeast is the reason that Hurricane Sandy caused so much damage.

He writes; "By increasing the value of shoreline property and encouraging rampant development, the trend toward privatizing formerly public space has contributed in no small measure to the damage storms like Hurricane Sandy inflict. Tidal lands that soaked up floodwaters were drained and developed. Jetties, bulkheads and sea walls were erected, hastening erosion. And sand dunes — which block rising waters but also profitable ocean views — were bulldozed." ...
Kahrl is saying that capitalism and the pursuit of aesthetic beauty nudged us to drop our guard and destroy Mother Nature's coastal defense system. .... For this claim to be true, he must assume that the tragedy of the commons would not have degraded such natural capital. This may be true.

Mother Nature is now engaging in a takings as she tries to seize coastal property from incumbent owners. I say let her win. These place based stakeholders want to use your tax dollars as funds to build a wall around them. A compromise would be for the state government to buy these properties and knock them down and revitalize the natural capital adaptation strategies that the author lists. ...

Thursday, November 29, 2012

'Bring Back Real Competition to the Telecom Industry'

Are you tired of paying too much for low-quality cable, internet, and phone services?:

Bad Connections, by David Cay Johnston, Commentary, NY Times: Since 1974, when the Justice Department sued to break up the Ma Bell phone monopoly, Americans have been told that competition in telecommunications would produce innovation, better service and lower prices.
What we’ve witnessed instead is low-quality service and prices that are higher than a truly competitive market would bring.
After a brief fling with competition, ownership has reconcentrated into a stodgy duopoly of Bell Twins — AT&T and Verizon. ...
The AT&T-DirectTV and Verizon-Bright House-Cox-Comcast-TimeWarner behemoths market what are known as “quad plays”: the phone companies sell mobile services jointly with the “triple play” of Internet, telephone and television connections, which are often provided by supposedly competing cable and satellite companies. And because AT&T’s and Verizon’s own land-based services operate mostly in discrete geographic markets, each cartel rules its domain as a near monopoly.
The result of having such sweeping control of the communications terrain, naturally, is that there is little incentive for either player to lower prices, make improvements to service or significantly invest in new technologies and infrastructure. And that, in turn, leaves American consumers with a major disadvantage compared with their counterparts in the rest of the world. ...
The remedy ... is straightforward: bring back real competition to the telecom industry. The Federal Communications Commission, the Justice Department and lawmakers have long said this is their goal. But absent new rules that promote vigorous competition among telecom companies, it simply won’t happen.
Just as canals and railroads let America grow in the 19th century, and highways and airports did so in the 20th century, the information superhighway is vital for the nation’s economic growth in the 21st. The nation can’t afford to leave its future in the hands of the cartels.

Wednesday, November 28, 2012

Hurricane Sandy’s Lesson on Preserving Capitalism

I thought I'd note this column from several weeks ago for two reasons. First, it was widely misinterpreted as supporting laws against price-gouging, but I didn't mean to disavow the price-system. The point was that there is a lesson in the public's reaction to price-gouging: When the public believes the price-allocation mechanism results in unfairness, they won't support it. Market fundamentalists, and those who support capitalism more generally, should worry more than they do about how increasing inequality or the increasing market and political power of those at the top will affect the public's perception of the fairness of the capitalist system. If the belief that the system is unfair crosses the tipping point, who knows what type of system could be adopted in its place. Second, and more to the point, I haven't had much luck finding things to post today, and no time to write something myself (so this is filler):

Hurricane Sandy’s Lesson on Preserving Capitalism: With long gas lines and other shortages putting people on edge in the wake of Hurricane Sandy, the usual post-disaster debate over the economics and ethics of price-gouging is underway. However, while the question of whether it is okay, even desirable, for businesses to raise prices after natural disasters is certainly important, there are larger lessons that can be drawn from this debate.
Economists do not like the term “price-gouging.” They believe that price increases are the best way to allocate scarce goods and services after a natural disaster and, importantly, to encourage additional supply. When people can make a large profit by supplying goods and services to a market, they will work extraordinarily hard to meet the demand.
But if there is such an advantage to allowing the price system to work after an event like Hurricane Sandy, why did producers often choose to stick with pre-disaster prices? Why would they leave profits on the table by maintaining pre-disaster prices and allocating goods through other mechanisms such as first-come, first-serve until supplies run out? One answer is that price-gouging after a natural disaster is illegal in many places. But this just begs the question. Why do so many places choose to prohibit large price increases in response to disaster induced shortages?
Most of the explanations economists have come up with rely upon the idea of fairness. ...[continue]...

Let me add one reference to a study by Daniel Kahneman I didn't know about when I wrote this supporting the notion that perceptions of unfairness undermine support for the price-allocation system:

As far as most economists are concerned, it would be totally reasonable for a grocery store to raise prices the day be for a hurricane. In fact, that's what's supposed to happen. If prices don't go up when demand increases, you wind up with shortages. To an economist, empty shelves at grocery stores are evidence that prices were too low.

In a famous study, the Nobel laureate Daniel Kahneman and his co-authors asked ordinary people lots of questions about pricing and fairness. In one question, a hardware store raised the price of snow shovels from $15 to $20 the morning after a snowstorm.

The higher price sends a signal to the world that says: Send more snow shovels! Someone who runs a hardware store an hour away might be inspired by to put a bunch of shovels in the back of a truck and bring them to town, easing a potential shortage and, perhaps, driving prices back down.

But, not surprisingly, eighty percent of people surveyed said raising the price of snow shovels after a storm would be unfair. Presumably, those people would also say it's unfair for a store to double prices on canned food the day before a hurricane.

People feel so strongly about this that they've passed price-gouging laws in many states, banning merchants from raising prices during hurricanes or other natural disasters.

'Death of a Prediction Market'

Rajiv Sethi on the "death of a prediction market":

Death of a Prediction Market: A couple of days ago Intrade announced that it was closing its doors to US residents in response to "legal and regulatory pressures." American traders are required to close out their positions by December 23rd, and withdraw all remaining funds by the 31st. Liquidity has dried up and spreads have widened considerably since the announcement. There have even been sharp price movements in some markets with no significant news, reflecting a skewed geographic distribution of beliefs regarding the likelihood of certain events.

The company will survive, maybe even thrive, as it adds new contracts on sporting events to cater to it's customers in Europe and elsewhere. But the contracts that made it famous - the US election markets - will dwindle and perhaps even disappear. Even a cursory glance at the Intrade forum reveals the importance of its US customers to these markets. Individuals from all corners of the country with views spanning the ideological spectrum, and detailed knowledge of their own political subcultures, will no longer be able to participate. There will be a rebirth at some point, perhaps launched by a new entrant with regulatory approval, but for the moment there is a vacuum in a once vibrant corner of the political landscape.

The closure was precipitated by a CFTC suit alleging that the company "solicited and permitted" US persons to buy and sell commodity options without being a registered exchange, in violation of US law. But it appears that hostility to prediction markets among regulators runs deeper than that, since an attempt by Nadex to register and offer binary options contracts on political events was previously denied on the grounds that "the contracts involve gaming and are contrary to the public interest."

The CFTC did not specify why exactly such markets are contrary to the public interest, and it's worth asking what the basis for such a position might be.

I can think of two reasons, neither of which are particularly compelling in this context. First, all traders have to post margin equal to their worst-case loss, even though in the aggregate the payouts from all bets will net to zero. This means that cash is tied up as collateral to support speculative bets, when it could be put to more productive uses such as the financing of investment. This is a capital diversion effect. Second, even though the exchange claims to keep this margin in segregated accounts, separate from company funds, there is always the possibility that its deposits are not fully insured and could be lost if the Irish banking system were to collapse. These losses would ultimately be incurred by traders, who would then have very limited legal recourse.

These arguments are not without merit. But if one really wanted to restrain the diversion of capital to support speculative positions, Intrade is hardly the place to start. Vastly greater amounts of collateral are tied up in support of speculation using interest rate and currency swaps, credit derivatives, options, and futures contracts. It is true that such contracts can also be used to reduce risk exposures, but so can prediction markets. Furthermore, the volume of derivatives trading has far exceeded levels needed to accommodate hedging demands for at least a decade. Sheila Bair recently described synthetic CDOs and naked CDSs as "a game of fantasy football" with unbounded stakes. In comparison with the scale of betting in licensed exchanges and over-the-counter swaps, Intrade's capital diversion effect is truly negligible.

The second argument, concerning the segregation and safety of funds, is more relevant. Even if the exchange maintains a strict separation of company funds from posted margin despite the absence of regulatory oversight, there's always the possibility that it's deposits in the Irish banking system are not fully secure. Sophisticated traders are well aware of this risk, which could be substantially mitigated (though clearly not eliminated entirely) by licensing and regulation.

In judging the wisdom of the CFTC action, it's also worth considering the benefits that prediction markets provide. Attempts at manipulation notwithstanding, it's hard to imagine a major election in the US without the prognostications of pundits and pollsters being measured against the markets. They have become part of the fabric of social interaction and conversation around political events.

But from my perspective, the primary benefit of prediction markets has been pedagogical. I've used them frequently in my financial economics course to illustrate basic concepts such as expected return, risk, skewness, margin, short sales, trading algorithms, and arbitrage. Intrade has been generous with its data, allowing public access to order books, charts and spreadsheets, and this information has found its way over the years into slides, problem sets, and exams. All of this could have been done using other sources and methods, but the canonical prediction market contract - a binary option on a visible and familiar public event - is particularly well suited for these purposes.

The first time I wrote about prediction markets on this blog was back in August 2003. Intrade didn't exist at the time but its precursor, Tradesports, was up and running, and the Iowa Electronic Markets had already been active for over a decade. Over the nine years since that early post, I've used data from prediction markets to discuss arbitrageoverreactionmanipulationself-fulfilling propheciesalgorithmic trading, and the interpretation of prices and order books. Many of these posts have been about broader issues that also arise in more economically significant markets, but can be seen with great clarity in the Intrade laboratory.

It seems to me that the energies of regulators would be better directed elsewhere, at real and significant threats to financial stability, instead of being targeted at a small scale exchange which has become culturally significant and serves an educational purpose. The CFTC action just reinforces the perception that financial sector enforcement in the United States is a random, arbitrary process and that regulators keep on missing the wood for the trees.

Tuesday, November 27, 2012

Cyberattacks on Banks Escalating

President of the Atlanta Fed, Dennis Lockhart:

...A real financial stabiliy concern ... is the potential for malicious disruptions to the payments system in the form of broadly targeted cyberattacks. Just in the last few months, the United States has experienced an escalating incidence of distributed denial of service attacks aimed at our largest banks. The attacks came simultaneously or in rapid succession. They appear to have been executed by sophisticated, well-organized hacking groups who flood bank web servers with junk data, allowing the hackers to target certain web applications and disrupt online services. Nearly all the perpetrators are external to the targeted organizations, and they appear to be operating from all over the globe. Their motives are not always clear. Some are in it for money, while others are in it for what you might call ideological or political reasons.
Unlike other cybercrime activity, which aims to steal customer data for the purpose of unauthorized transactions, distributed denial of service attacks do not necessarily result in stolen data. Rather, the intent appears to be to disable essential systems of financial institutions and cause them financial loss and reputational damage. The intent may be mischief on a grand scale, but also retaliation for matters not directly associated with the financial sector.
Banks have been defending themselves against cyberattacks for a while, but the recent attacks involved unprecedented volumes of traffic—up to 20 times more than in previous attacks. Banks and other participants in the payments system will need to reevaluate defense strategies. The increasing incidence and heightened magnitude of attacks suggests to me the need to update our thinking. What was previously classified as an unlikely but very damaging event affecting one or a few institutions should now probably be thought of as a persistent threat with potential systemic implications.
I'm drawing your attention to this area of risk... But I feel the need to be measured about the potential for severe financial instability from this source. In my judgment, cyberattacks on payments systems are not likely to have as deep or long lasting an impact on financial system stability as fiscal crises or bank runs, for example. Nonetheless, there is real justification for a call to action. ...
Even broad adoption of preventive measures may not thwart all attacks. Collaborative efforts should be oriented to building industry resilience. Resilience measures would be similar to those put in place in the banking industry to maintain operations in a natural disaster—multiple backup sites and redundant computer systems, for example.

Monday, November 26, 2012

'Wreaking Havoc on the Environment with Little or No Accountability'

Jeff Sachs says "polluters must pay":

Polluters Must Pay: When BP and its drilling partners caused the Deepwater Horizon oil spill in the Gulf of Mexico in 2010, the United States government demanded that BP finance the cleanup, compensate those who suffered damages, and pay criminal penalties for the violations that led to the disaster. BP has already committed more than $20 billion in remediation and penalties. Based on a settlement last week, BP will now pay the largest criminal penalty in US history – $4.5 billion.
The same standards for environmental cleanup need to be applied to global companies operating in poorer countries, where their power has typically been so great relative to that of governments that many act with impunity, wreaking havoc on the environment with little or no accountability. As we enter a new era of sustainable development, impunity must turn to responsibility. Polluters must pay, whether in rich or poor countries. Major companies need to accept responsibility for their actions. ...
I can't see the companies doing this voluntarily.

Sunday, November 25, 2012

Banking Must not be Left in the Shadows

I agree with Gary Gorton:

Banking must not be left in the shadows, by Gary Gorton, Commentary, Financial Times: ... Addressing the details of the recent financial crisis leaves open the larger question of how it could have happened in the first place. ... One of the findings of the Financial Stability Board report is that the global shadow banking system grew to $62tn in 2007, just before the crisis. Yet we are only now measuring the shadow banking system. ...
Measurement is the root of science. Our measurement systems, national income accounting, regulatory filings and accounting systems are useful but limited. ... Now we need to build a national risk accounting system. The financial crisis occurred because the financial system has changed in very significant ways. The measurement system needs to change in equally significant ways. The efforts made to date focus mostly on “better data collection” or “better use of existing data” – phrases that, at best, suggest feeble efforts. A new measurement system is potentially forward-looking in detecting possible risks.
Another problem is conceptual. Why weren’t we looking for the possibility of bank runs before the crisis? The answer is that we did not believe a bank run could happen in a developed economy. ... Why did we think that? For no good reason. But, when an economic phenomenon occurs over and over again, it suggests something fundamental... Another law, we now know, is that privately created bank money is subject to runs in the absence of government regulation.

I'll just add the periodic reminder that we do not yet have the regulation in place that is needed to address the problem of bank runs of "privately created bank money." Gary Gorton is skeptical that we can ever solve this problem, that's one of the pointsof th ecolumn, but if that's the case then we should be doing all we can to ensure that the consequences of a shadow bank run are minimized, and there is much more we can do along these lines.

Thursday, November 22, 2012

Who Should Lead the SEC?

I don't know enough about this -- what more can you tell me about who should lead the S.E.C.?:

Mary Miller vs. Neil Barofsky for the S.E.C.?, by Simon johnson, Commentary, NY Times: The Obama administration is floating the idea that Mary J. Miller, under secretary for domestic finance at the Treasury Department, could become its nominee to lead the Securities and Exchange Commission. Ms. Miller, a longtime executive in the mutual funds industry, has served in the Treasury under Timothy Geithner since February 2010.
Ms. Miller represents the financial sector's preferred approach to financial reform - some talk but very little by way of serious effort. ... And there is no willingness to really face down powerful people on Wall Street.
Her potential candidacy faces ... obstacles... Mr. Barofsky is the most important obstacle... The former special inspector general for the Troubled Assets Relief Program ... he is an experienced prosecutor who understands complex financial fraud. ... Mr. Barofsky is a lifelong Democrat who has enjoyed bipartisan support in Congress. ...
A petition that Credo Action has put online urging President Obama to appoint an S.E.C. chairman who will hold Wall Street accountable, and naming Mr. Barofsky as a worthy choice, had more than 35,000 signatures by Wednesday morning.
The petition also recommends former Senator Ted Kaufman of Delaware and Dennis Kelleher of Better Markets - both of whom I endorsed here last week - and it expresses support for Sheila Bair, who would be terrific ...
Mr. Barofsky is not popular with Mr. Geithner, precisely because he has stood up to authority for all the right reasons. ... The mutual fund industry does not want reform...
Choosing a new chairman of the S.E.C. is the perfect time for President Obama to decide whether, despite everything, to go for the status quo - which brought us to our current economic predicament - and nominate Ms. Miller for the S.E.C. Or does he really want effective change? In that case, he should nominate Mr. Barofsky or someone who can match his stellar qualifications.

Wednesday, November 21, 2012

'Drug Company Money is Undermining Science'

Charles Seife:

How Drug Company Money is Undermining Science, by Charles Seife, Scientific American: ...In the past few years the pharmaceutical industry has come up with many ways to funnel large sums of money—enough sometimes to put a child through college—into the pockets of independent medical researchers who are doing work that bears, directly or indirectly, on the drugs these firms are making and marketing. The problem is not just with the drug companies and the researchers but with the whole system—the granting institutions, the research labs, the journals, the professional societies, and so forth. No one is providing the checks and balances necessary to avoid conflicts. Instead organizations seem to shift responsibility from one to the other, leaving gaps in enforcement that researchers and drug companies navigate with ease, and then shroud their deliberations in secrecy.
“There isn't a single sector of academic medicine, academic research or medical education in which industry relationships are not a ubiquitous factor,” says sociologist Eric Campbell, a professor of medicine at Harvard Medical School. Those relationships are not all bad. After all, without the help of the pharmaceutical industry, medical researchers would not be able to turn their ideas into new drugs. Yet at the same time, Campbell argues, some of these liaisons co-opt scientists into helping sell pharmaceuticals rather than generating new knowledge.
The entanglements between researchers and pharmaceutical companies take many forms. There are speakers bureaus: a drugmaker gives a researcher money to travel—often first class—to gigs around the country, where the researcher sometimes gives a company-written speech and presents company-drafted slides. There is ghostwriting: a pharmaceutical manufacturer has an article drafted and pays a scientist (the “guest author”) an honorarium to put his or her name on it and submit it to a peer-reviewed journal. And then there is consulting: a company hires a researcher to render advice. ...
It is not just an academic problem. Drugs are approved or rejected based on supposedly independent research. When a pill does not work as advertised and is withdrawn from the market or relabeled as dangerous, there is often a trail of biased research and cash to scientists. ...
The scientific community's answer to the conflict-of-interest problem is transparency. Journals, grant-making institutions and professional organizations press researchers to openly declare ... when they have any entanglements that might compromise their objectivity. ... It is an honor system. Researchers often fail to report conflicts of interest—sometimes because they do not even realize that they present a problem. ...
In theory, there is a backup system. ... When a scientist fails to report such a conflict, the university or hospital he or she works for is supposed to spot it and report it. And when a university or hospital is not doing its job catching conflicted research, then the government agency that funds most of that research—the National Institutes of Health—is supposed to step in. Unfortunately, that backup system is badly broken. ...

Friday, November 16, 2012

Solving the Too Big to Fail Problem

William Dudley, President of the NY Fed, on too big to fail (this is just a small part of his much longer, detailed discussion):

Solving the Too Big to Fail Problem, by William C. Dudley, President and Chief Executive Officer, FRBNY: ...I am going to focus my remarks today on what is popularly known as the “too big to fail” (TBTF) problem. In particular, should society tolerate a financial system in which certain financial institutions are deemed to be too big to fail? And, if not, then what should we do about it?

The answer to the first question is clearly “no.” We cannot tolerate a financial system in which some firms are too big to fail—at least not ones that operate in any form other than that of a very tightly regulated utility.

The second question is the more interesting one. Is the current approach of the official sector to ending TBTF the right one? I’d characterize this approach as reducing the incentives for firms to operate with a large systemic footprint, reducing the likelihood of them failing, and lowering the cost to society when they do fail. Or would it be better to take the more direct, but less nuanced approach advocated by some and simply break up the most systemically important firms into smaller or simpler pieces in the hope that what emerges is no longer systemic and too big to fail?1

As I will explain tonight, I believe we should continue to press forward on the first path. But, if we fail to reach our destination by this route, then a blunter approach may yet prove necessary. ...

Critics of our approach believe it would be better to just break up firms deemed TBTF now—perhaps through legislation requiring the separation of retail banking and capital markets activities or by imposing size restrictions that require firms to shrink dramatically from their current scale. My own view is that while this could yet prove necessary, it is premature to give up on the current approach: changing the incentives facing large and complex firms, forcing them to become more resilient, and making the financial system more robust to their failure.

In my opinion, there are shortcomings to reimposing Glass-Steagall-type activity restrictions or strict size limits. With respect to Glass-Steagall, it is not obvious to me that the pairing of securities and banking businesses was an important causal element behind the crisis. In fact, independent investment banks were much more vulnerable during 2008 than the universal banking firms which conducted both banking and securities activities. More important is to address the well-known sources of instability in wholesale funding markets and give careful consideration to whether there should be a more robust lender of last resort regime for securities activities.

With respect to size limitations, it is important to recognize that a new and much reduced size threshold could sacrifice socially useful economies of scale and scope benefits. And it could do this without actually solving the problem of system risk externalities that aren’t related to balance sheet size.

Evaluating the socially optimal size, scope and organizational structure of financial firms is a complicated business, and so is establishing a viable transition path to a system of much smaller firms. It would be helpful in this regard if advocates of break-up solutions would put a bit more flesh on the bones and develop detailed proposals that address essential questions of how such downsizing or functional separation would be accomplished, and what benefits and costs could be expected.

Such an analysis should answer several questions: How would you force divestiture (in good times and bad)? Should firms be split up by activity or reduced pro-rata in size? How much would they have to be shrunk in order for the externalities of failure to no longer create TBTF problems? How would global trading and investment banking services and network-type activities be supported? Should some activities be retained in natural monopoly form, but subject to utility type regulation? How costly would it be to replicate support services or to manage liquidity and capital locally? Are there ways of designing size limits that cannot be arbitraged by banks via off-balance-sheet structures and other forms of financial innovation? So far, advocacy for the break-up path has been strong, but without the detail to assess whether this is indeed superior to the course we are currently following. But, I’m open-minded.

It is important to recognize that any credible approach to addressing the TBTF problem, including the one we are pursuing today, necessarily implies changes to the structure and business mix of financial firms and financial markets. Moreover, it is important to stress that not all of these adjustments will be in the private interests of these firms, and some will result in changes to the price and volume of certain financial services. These are intended consequences, not unintended consequences.

Too big to fail is an unacceptable regime. The good news is there are many efforts underway to address this problem. The bad news is that some of these efforts are just in their nascent stages. It is important that as the crisis recedes in memory, that these efforts not flag—this is a project that needs to be seen to a successful conclusion and then sustained on a permanent basis.

Thank you...

One thing we really need to understand better is the minimum efficient scale for various financial activities. Whenever the topic of breaking banks into smaller pieces is raised, we hear that a "much reduced size threshold could sacrifice socially useful economies of scale and scope benefits." The key word is "could." As far as I can tell, the evidence on this point is very shaky -- we just don't know for sure what size is necessary to exploit efficiencies. My own view is that it is likely smaller than many firms today, and hence there would be no harm in reducing firms size. This may not help much with stability, but there are still perhaps many benefits (e.g. reduced political and economic power) from reducing firm size and increasing the number of institutions engaged in important financial activities.

Tuesday, November 13, 2012

'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.

Thursday, November 08, 2012

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.