Posted by: bmeverett | March 29, 2009

Comments on “The Quiet Coup”


One of my Fletcher students sent me a recent article about the current financial crisis entitled “The Quiet Coup” from The Atlantic Monthly and asked for my comments. Here goes.
Simon Johnson, the author of the Atlantic article, blames our current problems on an excessively powerful financial lobby which convinced both Republican and Democrat legislators to do what was in the financial industry’s interest. He compares us to a developing country with its corruption and cronyism. This view is a bit too cute. The US is not a Banana Republic. Industries by and large dislike regulation and would prefer to be free to do as they wish. In economic theory, market competition, not the good will of capitalists, protects us from greed. In general, free markets perform this function well. The problem arises when government responds to requests for “rent-seeking” – the ability to earn above-market returns through the creation of artificial anti-competitive conditions. The finance industry bears a great deal of blame for excessive risk and poor performance, but the government is primarily responsible for the spillover of these problems to taxpayers.
The drive to increase home ownership has always been an understandable impulse for politicians. Government used a series of carrots and sticks to get banks to loan money to people who shouldn’t have qualified. The stick was withholding of merger approval and the carrot was Fannie Mae and Freddie Mac. The deal offered to the banks was: lend money to everyone, pocket the fees and the government will buy the loan and transfer the risk from you to the taxpayer. I’m not at all sure the banks would ever have initiated such a deal. The popularity of home ownership, however, is just too tempting to politicians.
The other great mistake was the repeal of Glass-Steagall in 1999 at the urging of two conservative Republicans – Phil Gramm of Texas and Jim Leach of Iowa. Opening up markets is a great instinct and should be encouraged. But not in this case. The purpose of Glass-Steagall, enacted in 1933, was to isolate commercial banking from the rest of the capital market. Deposits in commercial banks would be insured by the FDIC, and commercial banks would be required to invest the money in low-risk activities such as home mortgages, car loans, small business loans, etc. The riskier parts of the capital markets were managed by investment banks. Glass-Steagall prevented banks from mixing the two activities. The repeal of Glass-Steagall removed this separation, allowing taxpayer-insured deposits to flood into risky markets. Whether or not the original idea of Glass-Steagall was right, a federal deposit insurance program requires segregation. Otherwise, banks can borrow money and take it to Las Vegas. If they win, they keep the gain. If they lose, the taxpayer is on the hook.
We need to fix this problem. The federal government has the constitutional power “To coin money, regulate the value thereof, and of foreign coin…” (Article 1, Section 8). At the time of the founding of the Republic, money meant currency and coins. In a modern economy, the money supply means bank deposits – hence the government’s power to regulate. I favor reinstituting Glass-Steagall and insulating the commercial banking sector with high capital requirements and limits on investment risks. If we’re not going to do this, the only alternative is to eliminate the FDIC altogether.
We could, if we wish, do something similar for insurance companies like AIG, setting strict capital requirements and limiting their ability to branch out into high-risk ventures. Government seems more interested in limiting insurance premiums and executive salaries than in supporting a solvent insurance sector.
The other fix we need is to stop the bailouts and make use of bankruptcy proceedings. The idea of bankruptcy law is simple. If the company is hopeless, shut it down and pay out its available assets in an orderly manner to employees, suppliers, lenders, preferred shareholders and common shareholders. The farther down this list you are, the more risk you voluntarily took and the more pain you will have to endure. If the company is still a going concern, but has too much debt or other obligations, the court can abrogate all the contracts and restructure the business so it can move forward on a sustainable basis. This type of bankruptcy, usually under Chapter 11, will generally wipe-out the shareholders, the management and some or all of the bondholders. Labor contracts are gone as are any deals with suppliers or distributors.
For the life of me, I can’t see why we didn’t do that with Citibank, Bank of America, AIG, GM, Ford and Chrysler. Why are the managements of these companies still in place? Why are their shares still trading on the stock exchange? Why are UAW retirees enjoying benefits out of reach to employees of successful companies? If GM went through bankruptcy, it would come out the other end smaller, but competitive. Right now, it’s in a coma on life support. The same is true for Citibank. If it had been broken up, its toxic assets could have been taken over by government and deposited in a “bad bank” for ultimate resale. The branches would still be open, the employees still employed and the bank still functioning, albeit under a different name or names. The management would be out on the street, and the shares would be worth nothing. In the case of AIG, the taxpayer paid off the counterparties to very high-risk investments. This makes no sense at all. People who voluntarily take on risk should not be compensated by taxpayers.
Johnson is quite right that investment bankers did not know what they were doing and took way more risk than they thought they were taking. To really understand this problem, read the wonderful book “Fooled by Randomness” by Nassim Nicholas Taleb, a former bond trader. Taleb’s very convincing thesis is that Wall Street was enamored of a kind of quantitative analysis that assumed that historical data told us everything that could happen in markets. Most traders using this approach ultimately “explode” when the unexpected happens. And it’s been happening a lot lately. The key point here is that people who take risk should be allowed to take it – and suffer the consequences. Structures that put taxpayers on the hook for these losses are crazy.
The answer to these problems lies in sensible regulation, not in either more regulation or less regulation. Regulations, however, should not extend to the ability to preemptively take control of private companies or to control their executive compensation. Bankruptcy laws, properly enforced will provide all the incentive managers need to succeed. If managers fail, they should be out. There is a legitimate issue regarding overpayments to unsuccessful managers, but that is an issue of corporate governance to be addressed by shareholders, not the government.
I have no confidence that the current administration knows what they are doing. Their approach so far is simply incoherent. They are showing us no set of principles regarding the roles of markets and of government. They are attacking problems ad hoc in a way that Johnson aptly calls “policy by deal.” This approach is perfectly rational for people whose only analytical tool is the focus group, but we should not expect lasting positive results.
The article concludes “What we face now could, in fact, be worse than the Great Depression….” Americans seem to have developed a fascination with The Apocalypse. The History Channel, the Discovery Channel and even The Weather Channel are filled with programs entitled “Megadisasters,” “The Perfect Disaster”, “Life after People” and “It Could Happen Tomorrow.” Climate Change activists are very quick to believe in catastrophic global warming, although the science doesn’t support any of the extreme scenarios. Part of the problem is competition among media outlets for audience attention. A program entitled “The Future is probably OK” is not going to compete with “Asteroid Apocalypse” for the average TV watcher looking for something interesting. Economic reporting is the same.
The US economy has grown dynamically for over 200 years, despite recessions, panics and depressions. The free market has extraordinary resilience if left to function. The Great Depression of the 1930s was a creature of government policy, which turned a 1-2 year recession into a 10 year disaster through extreme protectionism and excessive government meddling in capital markets. There is no reason as yet to believe that the current recession will be any worse than the 1982-83 recession. Most recessions are caused by bursting bubbles, like the dot-com bubble in 2000. The economy recovers and moves on.
At the end of the day, Americans can rely on two powerful forces. The first is the resilience of the market itself, which will sooner or later overcome the current problems. The second is our electoral system which will ultimately stop government excess. In my (perhaps overly optimistic opinion) the days of FDR are long gone, when a President could be reelected time after time while making the economy worse. I think we are smarter and less patient today. We’ll see.

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