"China mostly invests in activities that raise productivity, raising the amount of goods and services that they can produce. This could be manufacturing or infrastructure or various kinds of services. Agriculture lags but continues to get some new investment. And of course they pour money into education. I'm not a fan of the Chinese way of organizing their economy or their society.... But contrast their pattern of investment in recent years with ours. What sector in our economy has expanded more than any other? ....Finance.... What has this really added in terms of productivity?"
He adds:
"The ATM and the credit card were great breakthroughs, but they are old. What has "financial innovation" brought us since the 1980s? ....Because financial innovation has mostly facilitated a big increase in finance.
....Rent-seeking means effectively a tax extracted by one sector from the rest of the economy.... Finance is rent-seeking. The sector has devoted great resources to tilting all playing fields in its direction. Consumers are taken advantage of; consumer protection is vehemently opposed. And great risks are taken, with the downside handed off to the government (and the consumers again, as taxpayers). This downside protection allows an overexpansion of debt-financed finance - reaching the preposterous levels seen in mid-2008 and now re-emerging.
Finance in its modern American form is not productive. It is not conducive to further sustained economic growth. The GDP accruing from these activities is illusory - most of finance is simply a tax on what is done by more productive members of society and a diversion of talent away from genuinely productivity-enhancing activities.
The rise of China does not necessarily imply slowdown or demise for the United States. But if they specialize in making things and we specialize in finance, they will eat our lunch."
In Johnson's comments section, the Mike Rulle comment thread provides a useful counterpoint with good questions. The aptly-named Bond Girl offers, I think, the most common sense reply, StatsGuy the most detailed one. It's a good and worthwhile debate, because there is an element of overstatement in Johnson's formulation of finance as a pure rent-seeking industry.
On the other hand, you look at banks insisting on tying corporate loans to derivatives, and marketing "structured notes" to small investors before the smoke has even stopped issuing from the crash, and "rent seeking" seems like a pretty obvious description. This is an industry that hasn't changed a bit, or learned a thing - and significant aspects of what they do magnify both the probability and extent of losses in the economy.
This is not currently a left-wing vs. right-wing argument - vid. guys like Peter Schiff (getting cheered on Jon Stewart, no less!), and also some smart Democrat politicians among the other side. Obama's Consumer Protection initiative might even have a lot more going for it than the other side of the aisle will acknowledge.
This could become a partisan issue in future if the GOP remains clueless, Obama decides he needs a lifeline/scapegoat as his other economic policies catch up with him, and financial firms continue with deceptive and fraudulent practices on a grand scale, leading to further financial shocks. The perfect storm O is generating for the American economy (exploding deficits and unemployment, coming jumps in interest rates and inflation, imploding energy exploration and production) is the GOP's biggest asset, and most of them realize that.
Even as they fail to see that Wall Street is shaping up to be President O's biggest political asset, possibly even his "get out of jail free" card.
Sure, it would mean throwing all of his loyal, high-contribution financiers under the bus, but that never stopped O before with power at stake. Especially if the GOP is stupid enough to be uncritical of Wall Street practices beforehand, then offer a Pavlovian defense of the so-called "free market" afterward. All without further thought re: what that market truly needs in order to be transparent and efficient.
Fraud is not capitalism. Paper is not productivity.
It's time for a wide, deep rethink in America, coupled with quick action to address the seeds of the next crash. Which have already being planted, and could well bear fruit before 2012.
If we want to get off this path, it's going to take dedicated, smart critics on both sides of the aisle. Maybe then we'll get to a happy future of fewer lawyers, curbed financiers with lower average earnings presiding over a much more stable base system, and fewer public employees - and more engineers, more domestic energy, more science grads, and more domestic manufacturers (the latter 2 merging as we speak in some areas).
Throw in steady savings, and we could have a prosperous America again. Fail, and the best scenario looks like Britain's long economic fall from the grace. The worst scenario looks like Germany's.
When I think thoughts like this, what I wonder is how we can trust the regulators any more than the financiers, given the run up to our current economic problems. I favor the financiers because their damage tends to be shorter term so that it's easier to detect and correct. Government damage tends to happen slowly but far more powerfully when it finally collapses, and far more difficult to fix.
P.S. Think "Sarbanes-Oxley" for why a cure might be worse than the disease.
AOG, it could be. SarbOx has indeed occurred to me.
Having said that, there are steps we could take.
1. Ban and liquidate all credit default swaps. Straightforward, net benefit to the economy. Will hurt a small number of financial firms. That's a good trade, unless you get lots of campaign money from people in those firms. We need to raise the price of that money until it looks like a bad deal on both sides of the aisle.
2. Destroy High Speed Trading Program capabilities, by implementing forced, regulated delays to transactions that level the playing field and make fractional-second plays impossible. Again, straightforward, removes a dangerous and even less productive "innovation," creates clear market volume signals (right now, it's reported that 70% of trading volume is this froth scam), and ensures a basic aspect of fairness that any financial system needs if it's to remain credible with a broad public. As a right-wing guy, that last item is very important to me. A market that's broadly seen as rigged, or managed by crooks, is lethal to my vision of a free capitalist society.
3. Forced breakup of all "too big to fail" financial firms. Probably a net shareholder plus, and the extra protection it offers the public purse more than offsets any costs it may incur.
4. Re-introduce Glass-Steagell. Sorry, I agree with the Left here - in part because history shows that banks who abuse the new freedom will be bailed out with public money. If G-S will curtail the corporate welfareism and risk-taking with government backing, I'm all for it. I would also introduce narrow limits on the types of instruments such institutions can own, and revisit existing limitations for instruments like pension funds etc.
Beyond the moral hazard problem, the primary purpose of our nation's banks must be to secure peoples' savings entrusted to them. The G-S repeal and introduction of "innovations" has made them far less secure in this critical role, and that must be fixed if we want to encourage savings - a critical national priority. Meanwhile, the Internet offers plenty of options for people who wish to get into more exotic services than conventional savings and lending - without protection.
...says the life-long academician Simon Johnson whose "genuine productivity" consists of a list of publications.
Look I'll not dispute that we have serious problems but I find largely uncompelling, and Mike Rulle's comments to be spot on.
The biggest problems we have are the TBTF issue and the principle/agent issue - free call options on liquidity and put options on crap assets, written by the taxpayers, and free call options on profits written by firms for their employees. Premia must be extracted (and I do mean extracted).
TBTF is difficult especially because simply "breaking them all up" may be problematic in a world where giant, state supported banks roam the earth in support and defense of "national champion" industries. It simply may be impossible to do without the likes of a Citi et al, distasteful as I acknowledge that prospect to be.
Further, simple break up may not deal with the systemic risk if there is a lack of population diversity - a kind of monoculture - with all the little Citis holding the same kind of assets and taking the same kind of risks.
Systemic risk is not simply a matter of size.
I'll go Rulle one further. I've spent some considerable time the last several months on the topic of finance and investment and I'll tell you I can make a compelling case that it is arguably the most difficult and consequential profession outside of healthcare.
Productivity and automation increase. Human needs increase, but not as quickly. Our numbers are more or less constant; Moore's law does not apply to the number of cars or dishwashers we need.
Inevitably, the vaunted "real stuff" we seem to prize so highly will shrink as a percentage of GDP, and along with it, the proportion of manufacturing wages - the "good jobs making real stuff" so prized by everyone.
And in an ever more complex world, where the modalities of value and production multiply and interact, the potential to add value to the economy via "finance" - which is really the distributed control network for allocation and production - will increase.
So the fact that Finance accounts for a growing percent of GDP doesn't in and of itself bother me much. (Isn't it, in the present instance though, mostly indefensible bullshit? - ed Yes, but I'm talking about the pure principle that returns to Finance should be constant, because much of the au courant polemic is directed in support of that principle, without seriously questioning why that should be so - the fact that the proportion increases is taken as de facto evidence of rent seeking; there's plenty of more direct evidence of rent seeking).
And while I'm at it, I'd say that rising health care cost proportion doesn't bother me either (in principle).
If we live in a far future where most of what we call GDP is taken up with the pursuit of health, well being, entertainment, and information, automation, and the management and allocation of all of the above - and the percent of GDP occupied by so-called "real stuff" is at a historical low - let me ask folks - what the hell is so wrong with that?
It irks me that arguments are cast with a rational of "well this number is just so obviously wrong" or "this is clearly unsustainable"... is it? SRSLY? Has anyone given serious thought to the long term trends? What the hell does a 2050 economy with 3% trend real growth and a healthy and constant 50% proportion of manufacturing look like? Just how much "stuff" is that? Why should the rewards to allocation of resources - Finance - be stuck at 3%?
A nation of saving, "real stuff" producing folks with a fixed and low rate of compensation awarded to Financiers and Doctors - this is an attractive vision, but I'll be perfectly incendiary here and claim it's something of a fetish, a Romantic society which has a substantial appeal on both the Left and the Right. It claims to be a hard headed and realistic prescription but I'm unpersuaded. In fact I can't see but that the percent of our economy dedicated to "real stuff" is bound to shrink and I haven't seen much acknowledgment of this.
TBTF is difficult especially because simply "breaking them all up" may be problematic in a world where giant, state supported banks roam the earth in support and defense of "national champion" industries. It simply may be impossible to do without the likes of a Citi et al, distasteful as I acknowledge that prospect to be
-lewy14
Utter poppycock. TBTF is the road to serfdom. No thanks.
How is it in my interest as an American citizen to sacrifice virtually all of my value added labor for the rest of my life to very malefactors who've destroyed the world economy?
Systemic risk is not simply a matter of size
-lewy 14
Of course it isn't, it's a matter of regulation. Had this crisis been approached sensibly i.e placing obviously insolvent financial institutions into receivership and capitalizing a new nationalized entity to be run forevermore as a public utility (while reinstating key FDR era checks on what remains of private banking), and declaring the obscene Derivatives Beast (currently screaming towards a notational value of one QUADRILLION dollars) null and void... well where's the problem? Oh I do understand, the banksters would have been fucked (and hopefully indicted) but why would this be a problem for America?
If we live in a far future where most of what we call GDP is taken up with the pursuit of health, well being, entertainment, and information, automation, and the management and allocation of all of the above - and the percent of GDP occupied by so-called "real stuff" is at a historical low - let me ask folks - what the hell is so wrong with that?
-lewy14
Plenty
Like I said, TBTF is something of an anathema. On the other hand, so called "systemically important institutions" are perhaps - perhaps - something like standing armies, or nuclear weapons. Threats to the Republic, and to the world, not to mention terrible wastes of resources - and not things we can unilaterally dispense with, except to our own material disadvantage.
(In fact one might say the same thing about Central Banks; once the Bank of England was formed in 1694, eventually they would become indispensable organs of the nation state because of the competitive advantage they produced - this despite whatever merits the arguments against them might possess.)
I'm not sold on TBTF either, but I'm open to the arguments. If banks with enormous balance sheets and taxpayer guaranteed access to liquidity and capital are required to keep our own "national champions" competitive, then clearly some regulatory reform is necessary. But such institutions may in fact be required, because I don't see nation breaking up Deutche Bank / Soc Gen / BNP Paribas / HSBC / Stan Chart ... not to mention the Chinese state owned banks. Not gonna happen.
I heard the "big banks are necessary" argument made by an analyst; I found it intriguing and resolved to keep an open mind about it. But if it were shown that any "systemically important" institution could be dispensed with, then I would be foursquare for their abolition.
and declaring the obscene Derivatives Beast (currently screaming towards a notational value of one QUADRILLION dollars) null and void...
I hear this a lot. What it tells me is that you really don't know what derivatives are, or what notional value is. If you want to find out, I suggest you start by googling "vanilla swap"; beyond offering that I don't feel obliged to discuss it. My success rate in explaining derivatives to people who use the term "banksters" is zero; I've tried many times. Perhaps I lack skill.
But thanks for reading my admittedly long and off the wall comment.
a new nationalized entity to be run forevermore as a public utility
You want the government to run our financial sector? Two words: post office. Oh, and one more: Amtrack.
Mr. Kaztman;
I could be persuaded that your 1,2,4 are good ideas, but my real question is, how plausible do you think it is that our current ruling class could pass something like that? Perhaps I have become overly cynical but looking at, say, the "stimulus package", passed in the heat of a "national crisis" nevertheless managed to be loaded primarily with pork and payoffs and very little actual "stimulus". One need not spend long with the current proposed health care legislation to find the same sort of thing, regardless of the overall merits. That is what concerns me and it's not obvious (to me) that the rapaciousness of our currrent financial overlords is worse.
I contend that too big to fail business is an inevitable eventuality of too big to function government.
"inevitable eventuality"
Is that redundant? Can I get a ruling?
I'm a more than a little confused by modern financial practices and how they're related to real economics.
I was talking to a finance guy and he was telling me that we need big, sophisticated financial services because "corporations need money" to do things.
This argument sounds weird to me because a successful corporation should be sitting on a pile cash. After all, business is supposed to make money!
I've heard the argument that corporations don't have their own cash because they can make more money lending it around than investing it in themselves. This may be somewhat true, but it seems shaky to me. After all, isn't there a lot less overhead involved in spending money internally? Isn't it prudent to make sure that you have a ready supply of cash? A bank account (lock box? secure server?) seems a lot better than some sort of money market...
Maybe a successful company just wants to expand faster than their profits would normally allow. This makes sense for a small company but,
I suspect that the real reason why corporations need cash is because of the old "Barbarians at the Gate" phenomena. Mergers and Acquisitions folks have seized piles of money by saddling productive companies with huge debt. A company with huge debt doesn't necessarily have a shortage of cash on hand but...
---
Lots of ellipses, and these aren't very sophisticated financial instruments I'm trying to understand. Let alone the debt and risk hiding scams...
It seems to me that any laws to fix this year's scams will be useless against next year's. And of course, anyone who's good at financial scams can buy friends in Washington. This ensures that they'll have the right loopholes and bailouts to run better scams next year.
I'm left wondering: how many of these shenanigans would be possible if our money was gold instead of paper? I don't know. But I don't think that government backed paper can be anything other than a train wreck.
"his argument sounds weird to me because a successful corporation should be sitting on a pile cash. After all, business is supposed to make money!"
Shareholders probably wouldn't take kindly to their company sitting on a big pile of cash without a good reason.
Companies generally don't sit on big piles of cash for a number of reasons- one, they are supposed to make money, and sitting on money doesn't produce much more money. Two, its begging some shark to come buy up controlling interest and liquidate the company for quick cash. Finally, our corporate tax rates are so high in this country its wise to reinvest money quickly so the government doesn't grab it. You might not make a dime next year and the government won't be paying you back to cover your losses (unless you are a giant car company or financial service of course).
This kind of plays into what I call the 'Scrooge McDuck fallacy' of wealth. Wealthy people tend to understand wealth a lot better than most of us- and the first rule is that money exists to produce more money. Rich people don't fill swimming pools with hundred dollar bills (rappers excluded), because little pieces of paper have no intrinsic value. Money gets either spent or invested, and only a small part of a fortune is 'saved', because its not productive.
This is the problem with soaking the rich. Their money (contrary to Disney afternoon cartoon lore) isn't sitting in a giant bin that they swim in. Its invested or spent (on goods or services) which creates jobs and commerce. Whatever the government takes comes DIRECTLY from that stream. Maybe a landscaper doesn't get hired, or a NASDAQ company doesnt get their stock bought. Taxation takes money directly out of the economy and into the black suckhole we call a government.
Finally, our corporate tax rates are so high in this country its wise to reinvest money quickly so the government doesn't grab it. You might not make a dime next year and the government won't be paying you back to cover your losses (unless you are a giant car company or financial service of course).
...
Wealthy people tend to understand wealth a lot better than most of us- and the first rule is that money exists to produce more money.
My point exactly. It does not make sense to me that corporations should avoid having a big pile of cash when it's such a darn useful tool for making more money!
Hiding and borrowing requires paying a financial services overhead. Based on financial services "profits" this is huge overhead.
The financial services sector has enough money to buy the correct friends in Washington. Those financial services that don't buy the correct friends fail Bear Sterns style.
Having a good friend in Washington usually doesn't mean that you get an obvious handout. Usually it just means that you get laws passed like high corporate taxes that force corporations to use your services.
I'm trying to find a good way to get off this Merry-Go-Round. The best solution I can figure is to systematically keep things as simple as possible (for starters, maybe using a pretty metal that everyone wants as currency). If more people can figure out what's going on, probably it will be much more likely for someone to cry foul...
Coldtype's link to The Onion News Network video is hilarious!
You want the government to run our financial sector? Two words: post office. Oh, and one more: Amtrack
-Fred
You mean as opposed to the crooks running the system now? Our financial "system" is insolvent on account of massive fraud and incompetence and, now propped up entirely on the taxpayer's dime, the financial mandarins who cratered the system remain in the driver's seat demanding still more control.
Perhaps this is an example of the Stockholm Syndrome at work. The American public has been so completely bamboozled and frankly abused that, much like some battered women, they've come to embrace their tormentors.
Amtrack? Give it one tenth of what we spend on "defense" and any rough edges will be smoothed out and then some.
By the way Fred, the last letter I sent arrived at its destination without a hitch and every time I check the mail box for my mail it's there. I honestly can't remember the last time that wasn't the case. Funny how operating a system used by virtually every citizen of the republic as a public utility rather than an extractive profit mechanism for a miniscule elite seems to work out for the majority as a whole, where as the other thing...
I couldn't live without the Onion Joe.
lewy, as always, I really appreciate your arguments. The thoughts are always cogent, and based in study and experience. They add a lot, and if you ever feel like putting them in articles, please do.
I'm not so sure. Devalued dollar, plus higher fuel prices even before the dollar's drop factors in, plus limit to borrowing, equals more stuff made here. Throw in the potential growth of biomanufacturing for items like "grassoline," and those "real" sectors may indeed be headed for a cyclical comeback. Especially the ones that can export, and get paid in currencies that are rising in relative value.
Right now, I see an economy (not just a government - note that 130% consumer debt load) borrowing tons of money from abroad, in order to keep buying a lot of stuff from abroad. That is not sustainable, especially as other global economies rise, and begin investing to meet their own growing internal demand. As opposed to lending money to America that is never going to be paid back.
That wasn't sustainable even before Obama, but O's policies are definitely accelerating the reckoning point, in multiple ways.
And the world is taking notice. Nobody wants to crash the boat they already have tons invested in. But if you look, they're stepping back in a whole bunch of ways, hoping it can sink slowly so they can lower their dependence first.
So no, I don't think your scenario is sustainable, except at a significantly lower standard of living for all concerned. With the possible exception of the financiers, if they can continue to buy licenses to defraud - or become gateways to investing beyond America.
True. Question is what advantage they do produce to an economy. I'd be interesting in seeing that analyst's argument, and am open to hearing it, but right now I don't see it.
But let's assume this analyst is right. What rules should such institutions operate under, if so?
Canada has set up a system where there are basically 5 big national banks (Royal, TD, Bank of Montreal, CIBC, Bank of Nova Scotia), and everybody else. That structure is maintained by various laws, which restrict what other banks can do in Canada. This has kept American banks out of major roles in Canada, as it was designed to do. In Canadian terms, they're probably too big to fail - the demise of 1 might be contemplated, but only very reluctantly and absolutely not more than 1.
In exchange, however, those 5 "Tier 1" banks have had to accept significant limits on what they could and could not do. The result is a sector that avoided most of the American meltdown, and caught a brief cold while everyone south was on death's door. TD went from below 40th place to about 14th largest bank in North America recently. It didn't grow - the others shrank.
For the past decade or more, the Canadian banks have been very unhappy about those restrictions. They're less unhappy these days, because it turned out well. But it does illustrate that there's a strong flip side of government control that must go with any kind of "national champion" strategy that produces "too big to fail" financial institutions.
And given the record, there probably should be. If the politicians are going to end up being financially responsible anyway, then segregate that area and give them substantial regulatory responsibility as well. Once you enter this realm of "potential threat to the Republic, but can't be unilaterally dispensed with," it's a package deal.
Which, my right-wing colleagues is why we've just given control of the nukes back to people who are considered over-the-top control freaks, even by the US military's standards.
Same logic applies here. Either remove the threat via breakup, or accept that it's a national responsibility and those who choose it, choose the oversight as well.
Now, Politicians like Chris Dodd and Barney Frank show that this oversight will often be corrupt. AOG (#7) is absolutely right.
So be it. There's a remedy for that at election time. But there's no remedy for TBTF institutions who have a full claim on the public purse, but no responsibility to that public beyond their own enrichment.
That isn't capitalism. And it's what experience shows we're always going to get from them.
mark (#9): since "eventuality" is often used to refer to things that are not certain, I rule that it isn't redundant.
Plus, your point is true. Too big to fail governments and to big to fail businesses have always been, and will always be, an incestuous combination where the first always spawns the second.
Another, less obvious dilemma posed by TBTF is that even if you break up all the companies that are now deemed TBTF, it's just a matter of time before the usual scaremongers just redefine TBTF downward. In other words, "Bail out Huge Corporation X now, or the economy dies!" becomes "Bail out Smaller Corporations x1, x2, x3... x10,000 now, or the economy dies!"
"I'm not so sure. Devalued dollar, plus higher fuel prices even before the dollar's drop factors in, plus limit to borrowing, equals more stuff made here."
You can't just turn on manufacturing like you're turning on a lightswitch. Ok- in fact you pretty much CAN do it, but if our current atmosphere remains remotely in place, it will be practically impossible.
You can't make T-shirts in the US- not strictly because of labor, but because the manufacturers that dyed yarn closed up shops and either went overseas or shuttered. The problem is, those shops were grandfathered out of all the current environmental regulations etc. We're a nation born and bred in textiles and there are a bare handful (less and less all the time) that can legally and profitably make textiles.
That's just one example. Until and unless all the laws (national, state, and local), lawsuits, unions, OSHA, and all the other busy bodies deem it OK to keep making the same products using the same chemicals we have for 100 years, revitalizing our industries is just not possible in response to ANY realistic demand. And as we see rent seeking is really the only way this stuff gets done anymore. That is simply too expensive for such low cost items. Unless we want all our industries based on the likes of our auto industry...
And lets not fall in love with the romantic idea that tangible products equate to wealth. Service is as much a product as anything, and maybe more. When your wealthy and you have all the ipods and lexusi you could want, its service that you will exchange wealth for. We're at a place in our evolution where we buy time more than anything, and its just as big a revolution as when food no longer was the standard 'product' everyone bartered over.
"Service is as much a product as anything, and maybe more"
If it's exportable, yes. If not, no.
mark buehner:
bq."inevitable eventuality"
bq.
bq.Is that redundant? Can I get a ruling?
I think it is. Rather than saying something ".. is an inevitable eventuality" I'd just say it ".. is inevitable".
As for the subject of this post, I can't help but feel that absent government distortion of the financial markets via the creation of perverse incentives and protection of large corporations against competition from smaller businesses with better models, many of the things Mr. Katzman wants to ban wouldn't actually be a serious problem and therefore that I don't know that banning them is the best solution. However I'm not an economist so it's hard for me to be certain about that. Having said that economic cycles are also pretty much inevitable, claiming that we need to take drastic action each time a downturn occurs is just silly. It's fairly clear to me that a downturn is going to happen regardless, the only problem this time is that crazy market distortions made it much worse than it otherwise would have been.
Joe, thanks for the kind words. If there is some particular aspect of my meandering contrarian comments which you'd like to see expanded on or polished, let me know and I'll see if I can't craft a post or two.
I agree with what you said about oil and the dollar setting this country up for a cyclic recovery of exports, and further that this is a good thing, something to be encouraged at this point.
My comments, and I think mark buehner's, are aimed at the longer term. I share mark's distrust of a very long term reliance on manufacturing and manufactured goods. I fear it is a Romantic ideal.
The future holds some very tough bridges to cross. What will 2050 look like? The conservative political position has never begrudged returns to talent and contribution. The growing complexity of the world will enable more and more returns to accrue to the talented few. Manufacturing itself will become complex and automated to a degree which precludes more and more people from contributing. What happens when people in the left two thirds of the curve are mostly just in the way of people who are creating products, services, processes... wealth?
I don't have an answer but it's something to think about - and I bring it up because implied social visions seem to be driving much of the critique of the financial system, both on the right and the left. I'd like to see those implied visions made explicit, and justified.
With respect to the TBTF banks - yes, Canada is a good example. Also Australia. There is an Australian hedge fund guy (Bronte Capital) named John Hempton whose blog I follow - he made the point that there is one other aspect of the Canadian and Australian system which is little remarked on - it's a legal oligopoly/cartel, which guarantees a certain level of profitability and shelter from competition. Hempton argued (with some courage IMO) that this was a good thing; it does take courage to point it out.
So there is more friction in financial intermediation in those countries, but also a more stable banking system.
What price is paid? I think friction comes at a cost. I'm really opposed to the idea that returns to Finance (necessarily) represent "tax" or "waste" or "rent seeking" - I hear it as another flavor of the Leftist "everything is a zero sum game, you're gain will always come at my expense" kind of thinking. I believe low friction (read: innovative) financial intermediation can grow the whole pie.
[lewy ducks the rotten tomatoes here]
Yeah, this sounds like chutzpa on stilts in the context of the current crisis. But I feel it is important to point out since this kind of "zero sum" thinking grounds much of the criticism.
Let me try to put a small aspect of this simply. People have a need to borrow money - houses, credit cards.
They also have a need to lend money. Huh? Well, yeah: bonds are components of 401K plans, college savings plans, etc.
Now: when people want to borrow money, they want the right to pay off their debt slow if they have to, fast if they can.
When they lend money, they do not want to grant the right to the borrower to pay off early. They want a guaranteed income stream.
Quite simply, the kinds of debts people want to incur are not the kinds they want to own.
The features which make credit cards and modern mortgages appealing - the ability to pay down random amounts of principle, whenever - make these kinds of debts very difficult to value. (In finance lingo they have "negative convexity").
Financial alchemy - and the term is really appropriate - turns hard to value debt into easy to value debt. This is where swaps and other horrible "derivatives" come into play.
The American model of securitization, coupled with and enabled by the derivatives market, actually lowered the friction. This is not a bad thing, in and of itself. And friction is more than a lower "cost of money" - it's access to a broader variety of instruments which serve different needs.
One of the places where it went wrong is that simply too much debt has been created. The Fed could have prevented this; by now there is consensus that it should have. Debt bubbles are poisonous in a way that equity bubbles are not, and they are always and everywhere a systemic risk.
Another way things went wrong is a misalignment of incentives - cash bonuses for bottom line "profits" of dubious durability, based on investments of questionable prudentiality. This has to be fixed.
But the phenomena of a sense of entitlement to free options is not limited to the "banksters". As Rulle observed, one issue people are getting a rage-on about now is that of the overdraft fees.
Dial the Way-Back machine to the Good Old Days of Banking that some folks want to return to, and ask the teller about "overdraft protection". You'll get a blank stare.
In the old days, checks bounced. Remember? Yeah, financial innovation really sucks.
The bottom line for me is that once you are informed about the workings of finance, you aren't "captured", or an "apologist", or a "rent seeker" - there is still plenty to be enraged about - the problems are more apparent, they stand out like sore thumbs, and they're still present. Another bubble is being blown as we speak.
But I prefer to get my nostalgia from 80's oldies FM and my romanticism from anime - financial reform belongs to the realm of dreary technocracy. I don't see the past (or even necessarily other countries) as a model, and I don't have answers for how finance should fit in society - only questions.
And don't get me started about the Austrian school types who rail against "rent seeking" and bemoan the "theft" of inflationary fiat currencies, all the while digging gold out from one hole in the ground to bury in another and claiming they are experts on "true wealth". Is GATA right - is there a conspiracy against gold? God, I hope so. Maybe I will have to write a post... ;)
Excellent point, lewy. Partly true. But not wholly true.
Which is part of why I want to ban CDS. Valuing them properly approaches impossibility, and they are the antithesis of transparent. It's also not exactly debt, since credit default swaps have the effect of magnifying losses, and can easily be (and have been) set up as transactions that are fraudulent from the get-go.
Or look at the mortgage securitization. Easy to value is the LAST thing they are. Which should have led to regulatory brakes being applied, via required standards that ether forced the creation of full required transparency, or got the instruments dismissed as having too much inherent overhead to be saleable, before the markets had to come to the same conclusion.
For me, principles of value transparency and level base playing field for all participants are absolutely essential to any functioning market, irrespective of social vision. Treading on corporate freedom of action to achieve that is exactly what government is there to do, as a core function. The market is not an anything-goes floating casino, and turning it into one invites ruin on multiple levels.
Stability of the base personal savings system is also key, because if people start to doubt that at its fundamentals, we're economically screwed, the human cost is huge, and you can pretty much kiss capitalism goodbye because people will turn on it savagely.
At a lesser level of importance, the business cycle will always be with us, but the frequency and extent of crashes and bubbles are increasing. The Fed and the government bear a large share of responsibility for that, but there are also a number of developments on Wall Street that are making noticeable contributions.
I actually don't much buy the "misalignment of incentives" bit as a contributor, though. If firms that screw up badly enough are allowed to go bust, the corporate sector will figure the answers out much faster and more successfully than any government. The problem is a much bigger misalignment of incentives, at the government/ industry level. The individual compensation for risky behaviour, and lack of internal oversight, are just the trickle down.
As for undeserved furor about overdraft charges etc., that feature of the political system is inevitable under any financial framework, so I ignore it as extraneous noise. If the cost gets too high due to political interference, overdraft will become much more limited and more cheques will just bounce. And people will have got what they asked for, even if they don't like what they got. Problem solved, stable system before, stable system after.
It's the stuff that magnifies systemic instability that's a real problem for me.
Note that macroeconomic policy is beyond the scope of our discussion - if the feds decide to go the Zimbabwe route of monetized debt and hyper-inflation, no Wall Street rules or actions matter. So that's a separate area. Our discussion is within the purview of "how the markets need to operate within themselves, as contributors to a larger economy."
In that realm, financial alchemy is useful, but so is general faith in the financial system and markets. Right now, the level of industry externalities and associated personal consequence are eroding that, fast.
Again, some of that would have happened under any regulatory regime, because of federal policy that has promoted personal debt and created bubbles. That must be fixed. But so must the growing - and I think correct - perception that Wall Street is a rigged game. If that solidifies, arguments about federal culpability fall on deaf ears, and all the alchemy in the world won't be able to transform the lead shoes the financial industry will get to wear. Just before it's thrown into the Hudson.
That's a Tragedy of the Commons problem, however, which is why its guardian can't be the financial industry. Which leaves the government in its role of protecting capitalism from Wall Street, and Wall Street from itself. A role it is supposed to have. In that role, it may choose regulations that allow less innovation and growth, but also create more of a level playing field, more stability, and more trust in the financial system.
That's not a leftist zero-sum argument, it's an argument that "your balance of contribution is consistently trending negative, and we're raising your transaction costs and decreasing your available options in response."
Will regulation deliver that? Partially only. And there will be a cost associated with government attempts, due to incompetence, corruption, regulatory capture, etc. Those considerations must affect discussions re: what to do. To pick a different path and goal set entirely, however, there has to be an argument that either the goals i've stated are undesirable, or that there's another way to make dependable progress.
Joe I'm not in substantial disagreement with respect to the goals of stability and public confidence in the markets, but I have a different emphasis and a different (and perhaps more pessimistic take) on what is possible.
I don't believe the problem lies with particular instruments. I don't see CDS as being a cause of the crisis, despite the doomsaying and vastly inflated numbers around their total notional value.
Yes, AIG leveraged their AAA rating to write derivatives. So did Warren Buffet, who fed the popular ignorant rage against derivatives and then wrote tons of long term index puts - let me tell you, in principle, those are just as hard to value as CDS. Buffet is still solvent (though to be fair his investment in Wells and Goldman owes no small part to government lifelines). Buffet undertook this activity with prudence, AIG with absolutely none. I'd claim the problem is not the underlying activity, but, once again, the mis-alignment of incentives.
Ban CDS? Shall we make credit events off limits as being insurable? What about muni bond insurers? Mortgage insurers?
Yes, mortgage securities are somewhat hard to value - but individual mortgages are very hard to value. That's why you need the alchemists!
What's the difference between a CDO, a fixed income arbitrage hedge fund, and a good old fashioned bank? Implementation details, and regulation. Fundamentally they do the same thing and their components and techniques are homologous. All of them convert risky and irregular debt of negative convexity into safer, regular debt of positive convexity - using the techniques of pooling, joint-default calculations, maturity transformation, tranches (which produces the equity tranche), and credit enhancement (mortgage insurance, CDS).
Your friendly local old fashioned bank is just a kind of CDO!
I don't get the whole Glass-Steagell thing either. Lehman was at the heart of the mother of all bank runs (on the money market - a thirty year old "innovation") and it did not take commercial deposits. I don't see how G-S would have prevented the crisis.
I don't believe that the balance of the contribution of Finance is "consistently trending negative". I'd make a case that the real damage was done in 2002 to the present.
And I think "restricting options" (meaning the range of allowable activities) without addressing the underlying misalignment of incentives is not going to produce results. I rather think that addressing the misalignment of incentives will solve most if not all the problem.
The sketch of my solution would be to require firms and individuals to be exposed to downside as well as upside. The investment banks arguably took a wrong turn when they ceased to be a partnership and became a public company; the bankers there used to have equity, now they have call options - one sided outcomes. Heads they win, tails they walk away or get bailed out, and do it again.
Perhaps some class of institutions should be required to be capitalized by their principles, rather than be run by agents of passive principles - those passive principles being common shareholders. If the principles capitalized their risks directly, prudence would be more generally observed, regardless of the scope of the activity, and the risks around "innovation" more carefully considered. If you want to go retro, consider that direction.
And paying bonuses in kind is a great idea - pay bankers with the securities they create. One of the Swiss banks - either CS or UBS, I forget - paid a bunch of bonuses with a pool of toxic subprime mortgages. The bankers screamed like... like... boiled lobsters or something. ;). Totally effin' brilliant.
A small set of rules surrounding the capitalization of firms and the compensation of individuals who deal in financial risk is a better approach IMO than creating whitelists and blacklists of securities to create or trade.
The Fed should have a third leg to its two legged mandate of price stability and full employment: aggregate debt limit. The creation of aggregate debt in excess of the aggregate ability to service that debt must be prevented. ('course Treasury debt counts too; if I could give the Fed veto power over the budget, I'd be tempted..) OTOH equity bubbles like the .com bubble can and should be left alone.
If these measures had been in place, IB leverage would have been reduced, mortgage fraud weeded out, short rates would have risen sharply 2004 or so. Aggregate debt creation would have leveled off much sooner, and the savings glut from China and the ME would have found a terrible scarcity of dollar debt, regardless of how low they bid down long rates.
My pessimism comes from a sinking feeling I have that any sufficiently globally competitive financial system will be too unstable to survive without some government support, that the complexities and scary realities of Finance will never achieve popular understanding and support, and that the long benevolent period of disinflation from 1983 to 2000 or so is ended, and that this, combined with potential resource scarcity, will make "boom and bust" substantially more common going forward, regardless of the reforms taken.
The cure for Too Big To Fail is, and was, bankruptcy. Just allow Citi & Goldman & JP Morgan to fail, as Lehmann was allowed to fail -- and improve the bankruptcy proceedings to speed allocation of investment/ speculation losses.
Long Term Credit Management should have been allowed to fail -- and the investment speculators who lose would learn, and other wise potential would have learned, to avoid 'too risky' derivatives. Instead, they all learned that the gov't will bail out big banks; at least some of them.
America doesn't have a 'national airline' -- and doesn't need any Big Banks for national protection.
The key is Return on Investment, risk adjusted. The current problem was the stupid rocket science finance (like global warming models?) that saw house prices going up for years, and calculated terrible probabilities for default and house value decreases. Based on such lousy models, instead of pricing a housing price value drop as almost inevitable, it priced such a drop as almost impossible.
And all the top Big Banks used similar pricing models & values and traded securitized loans with woefully inadequate risk adjustment value components.
Let's also remember that such Finance got so many new houses built that now there's a housing glut -- isn't this the 'real economy' kind of stuff anti-Finance folk say they want more of? (Joe?)
The principle to be supported -- prepare the legal framework so that any company can fail, any investment/speculation can lose value, and no additional gov't action should be needed.
The way to have economic progress is to focus new investment on those areas with a high ROI. Finance folk have generally been doing it better than gov't.
Oh, and if Goldman is allowed to fail, since it cannot fulfill its contracted obligations (tho it paid bonuses to its employees who created those obligations), if Goldman fails, all the workers will still be available to do any additional investment analysis. If there are uninvested dollars looking for advisors.