Arnold Kling  

Off the Record

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Yesterday evening, I attended a panel discussion on the financial crisis. The ground rules were that the discussion was off the record, which I will interpret as allowing me to comment on the content of the discussion, without disclosing who said what.

I was one of the panelists, and I spoke of the knowledge/power discrepancy. I probably exemplified it, as well. That is, I am not sure that the members of the panel knew much more than the members of the audience, but we had way much more power, if you measure power by speaking time. I don't regret anything particular that I said, but I wish I had given others more time.

One topic that came up was the principal-agent problem of financial firms. It was argued that managers took advantage of shareholders by taking undue compensation and excessive risks. I was one of those who believes that managers duped themselves and that they regret how this worked out for them personally. However, had the incentives been radically different (for example, if one could be sent to prison for improper risk-taking at a financial firm), I can imagine that fewer managers would have duped themselves.

My sense is that there is a widespread public perception that financial managers deserve to be punished more than they have been, regardless of whether such punishment is necessary or sufficient to deter excessive risk-taking. I think that if we are going to have government guarantees, then punishment as a deterrent is worth considering. For example, I would like to see those responsible for under-funding defined-benefit pension plans go to prison. Of course, we will not see that happen, since it would mean that every legislator would be behind bars.

Anyway, apply the principal-agent paradigm to government. Think of "we the people" as the principals and government officials as our agents. To me, the principal-agent problem involved with government is much worse, both in theory and in practice, than that involved with financial firms.

Another issue is transparency. In the used car market, if the government knew the true quality of every used car, then I presume it should disclose this information to get rid of the "lemons problem." Next, apply that to banks. If the government knew the true condition of every bank, and disclosed which ones were in trouble....there would be runs on those banks. So, in Megan McArdle's immortal words, "Money is weird. Finance is weird."

I do not think that the FDIC needs to disclose specifically which banks are in trouble. But I do think that there is a lack of transparency about the overall strategy of the Fed and Treasury. In particular, I do not think they are telling us what they don't know. They want us to believe that they know much more than they really do, because they don't want us to doubt their wisdom. In particular, my guess is that in some very important cases they do not know whether institutions face solvency issues or liquidity issues.

An important point is the fact that the financial crisis was not limited to the United States. If you think that the Community Reinvestment Act caused the housing bubble, then explain how it caused the housing bubbles in the UK and Spain.

To put this another way, if policymakers had used the bully pulpit or regulatory policy to stop the bubble in the middle of 2004, does that mean that everything would be fine now? Or would the "global savings glut," as Ben Bernanke famously called it, simply have gone and produced excesses and imbalances somewhere else? In other words, even if you had prevented the housing bubble, would some other bubble have taken its place?

We got into the question of whether the financial sector had gotten too big in this country. My belief is that it had, in the sense that too many financial institutions and financial instruments are guaranteed by the government, implicitly if not explicitly. Going forward, I think that the plan is to continue to guarantee an immense amount of stuff, but try to regulate more closely. I don't think that's such a good plan. In theory, I like the idea of a finite, guaranteed-and-regulated sector (banks with deposit insurance and tight limitations on activities) alongside a relatively unregulated sector that is more innovative and takes more risk. But in practice we seem to have difficulty both in keeping banks safe and in allowing an unregulated sector where failure is an option. The banks seem to find a way to take risks, and the unregulated folks seem to find a way to get guarantees.


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COMMENTS (17 to date)
Adam writes:

Arnold,

You remark that you "would like to see those responsible for under-funding defined-benefit pension plans go to prison." Not a bad idea, especially if you include the thousands of public officials across the country who either negotiated or voted for billions in underfunded pensions for public employees. Also, what about those in Congress who swear to protect Social Security payments while ignoring the looming unfunded liabilities? Sending all those negligent politicians to jail certainly would solve a lot of problems!

Best,

Adam

Thomas DeMeo writes:

Next, apply that to banks. If the government knew the true condition of every bank, and disclosed which ones were in trouble....there would be runs on those banks. So, in Megan McArdle's immortal words, "Money is weird. Finance is weird."

One would hope that such disclosure would a) be more incremental than you describe, and b) result in radically different behavior by the banks.

We still need to come to terms with the issue of speed. Modern markets are nearly frictionless and react too violently to new information. What little friction there is today will disappear in the near future.

anon writes:

The problem with the bifurcated regulatory approach is that interconnection risk must still be monitored and controlled.

The root of the agency problem is the investment banking culture (including compensation). This is what resulted in the rape of on balance sheet principal positions and a loss of more integrated risk control.

I see no solution other than top-down capital adequacy rules for the entire financial system. Comprehensiveness is a requirement in order to attack the risk of regulatory arbitrage on all fronts and directly.

Lee Adams writes:

A bailout that makes sense!

I'm in favor of giving $85,000,000,000 to
America in a 'We Deserve It Dividend'. To make the
math simple, let's assume there are 200,000,000 bona
fide U.S.Citizens 18+.

Our population is about 301,000,000 +/- counting every
man,woman and child. So 200,000,000 might be a fair stab at
adults 18 and up. So divide 200 million adults 18+ into $85
billion that equals $425,000.00.My plan is to give $425,000
to every person 18+ as a 'We Deserve ItDividend'.
Of course, it would NOT be tax free. So let's assume a
tax rate of 30%. Every individual 18+ has to pay$127,500.00
in taxes.

That sends $25,500,000,000 right back to Uncle Sam.But it
means that every adult 18+ has $297,500.00 in their pocket.

A husband and wife has $595,000.00. What would you do with
$297,500.00 to $595,000.00 in your family?

Pay off your mortgage - housing crisis solved.

Repay college loans - what a great boost to new grads

Put away money for college - it'll be there

Save in a bank - create money to loan to entrepreneurs.

Buy a new car - create jobsInvest in the market - capital
drives growth

Pay for your parent's medical insurance - health care
improves

Enable Deadbeat Dads to come clean - or else

Remember this is for every adult U S Citizen 18+ including
the folks who lost their jobs at Lehman Brothers and every
other company that is cutting back. And of course, for
those serving in our Armed Forces. If we're going to
re-distribute wealth let's really do it... instead of
trickling out a puny $1000.00 ( 'vote buy' )
economic incentive that is being proposed by one of our
candidates for President.

Caliban Darklock writes:

@Lee Adams:

$85,000,000,000 / 200,000,000 = $425

I'd prefer the $1,000.

liberty writes:

Lee:

200 million goes into 85 billion 425 times, not 425,000 times. We'd each get a stimulus check of $425.

In fact, we are also planning to spend about $100 billion doing something like that again soon. To give everyone $425,000.00 though, this would cost $85 trillion. That is a little harder to come by.

gbh writes:

Lee,

Your plan sounds a lot like Friedman's famous helicopter drop of money...

Adam writes:

Lee,

Great idea, but the math is a little off. $85 billion divided by 200 million is $425, not $425,000. But why not up the ante to $85 trillion so we can get our full $425,000 'We Deserve It' dividend.

The upshot of bailouts, redistribution, and regulation discussions is that they devolve into vain posturing and silliness. There is no benefit in ad hoc regulation and punishment. The new battered and bandaged system is sure to be worse than the system we started off with.

What about that idea of free banking discussed over on EconTalk?

Adam

Maniel writes:

The underlying problem, IMHO, is easy to identify and exceptionally difficult to solve: we have become a debt-based culture. The folks we send to Washington are indeed our agents; in the global sense, they do what we want them to do. While we are out borrowing to buy homes and stuff, our congressmen and women are working their little hearts out to find other people's money (i.e., borrowing and taxing) to send to us. Solution: transform ourselves into an equity-based culture and an equity-based economy.

Of course, if the government does send me the $425, I won't send it back.

Josh writes:

You guys all missed Lee Adams' point - he was talking about on having the government give out the $85B. It sounds about right to have the government spend roughly 1000x more than it originally planned on spending.

dWj writes:

In re "disclosing which banks are in trouble", simply closing them down would make sense. That aside, there was a recent article, I think from the Richmond Fed, about incentives banks have to provide nonpublic information to the regulators, and noted that gains from making information public will be short-lived as the regulators ultimately come to have much less private information. A bank might be reluctant to give a regulator information that would result in its being shut down, but it would be far more reluctant to provide regulators with incipient signs of weakness if it thought they would become public.

This is kind of the same endpoint you get, but for slightly different reasons.

Lord writes:

Would it have just led to another bubble?

Yes and no. Most likely there would have been some other bubbles, but they would have been much smaller as other asset classes simply can't support the shear size of the inflows. Interest rates would have fallen further, the search for yield grown more desperate, but there would have been little to churn. Debt may have been replaced with buying real property directly, as Japan did in the 80s, but these would have been much less troublesome except for the buyers.

Don the libertarian Democrat writes:

"We got into the question of whether the financial sector had gotten too big in this country. My belief is that it had, in the sense that too many financial institutions and financial instruments are guaranteed by the government, implicitly if not explicitly. Going forward, I think that the plan is to continue to guarantee an immense amount of stuff, but try to regulate more closely. I don't think that's such a good plan. In theory, I like the idea of a finite, guaranteed-and-regulated sector (banks with deposit insurance and tight limitations on activities) alongside a relatively unregulated sector that is more innovative and takes more risk. But in practice we seem to have difficulty both in keeping banks safe and in allowing an unregulated sector where failure is an option. The banks seem to find a way to take risks, and the unregulated folks seem to find a way to get guarantees."

That's the clearest statement of what I believe that I've read. Thanks.

Alex writes:

A major cause of the financial industry and firms getting too big was the idea of the government backstop. A firm assumes it can successfully operate assuming there isn't some major six, seven, eight sigma event (setting aside that these events occur much more regularly than the models often imply). Then if there is some catastrophic event, the government will be there to play life guard and save the day, so the firm doesn't need to prepare and plan for such an event. That is, the firm only prepares for moderate speed bumps not brick walls.

If the government focused less on limiting firms' risk and more on reducing systematic risk, firms have all the incentive needed to prepare for catastrophic risk. I'd like the impending regulation focus on how to isolate firms that are going down, while allowing the market to continue with little turbulence. I am not sure what types of activities will accomplish this, but merely attempting to cap risk is like the Dutch boy plugging the dyke.

Bill Woolsey writes:

The notion that firms must plan for rare disasters seems mistaken to me. When the rare disaster occurs, then the plan is for the firm to fail. Of course, a government bailout is always a possibility, and that reduces the risk of failure. But if there were no bailouts, it just seems implausible that firms would take care never to fail.

Since failure is always going to be a possibility, that means that those lending to firms must take it into account. In reality, bailouts (starting with FDIC) are generally of creditors, not firms. So the _real_ issue is that lenders don't require borrowers to take steps to reduce the possibility of failure because a bailout reduces the possiblity of loss.

All of this is basic textbook analysis of banking with FDIC. Banks used to have to maintain high capital ratios (relatively low leverage by banking standards,) in order to inspire confidence by depositors. After deposit insurance, depositors didn't care. Banks no longer needed to maintain high capital ratios to reassure depositors. This makes failure more likely, leaving FDIC to cover the losses.

In the last year, lenders to investment banks and share holders in mutual funds have been "bailed out." In the situation of the investment banks, perhaps this was predicted. So, the investment banks could borrow short to finance portfolios of mortgage backed securities. They didn't have to maintain much of a capital ratio (they were able to have high leverage) because their creditors didn't care. Those lending to investment banks expected to be bailed out. Perhaps.

George Berger writes:

Arnold

I don't understand your attachment to government-provided deposit insurance. Government provided deposit insurance creates moral hazard in spades and ultimately creates the very systemic risk that a banking system should try to avoid. It also invites government to impose further regulations in order to control risk-taking by banks. Impose capital adequacy regulations? This invites banks to expand off-balance sheet transactions or engage in accounting hanky-panky.

Charles Calomiris examines state deposit insurance systems (see "Do Vulnerable Economies Need Deposit Insurance: Lessons from US Agriculture in the 1920s" in If Texas Were Chile, edited by Philip Brock) and finds that depositors in insured systems had higher losses, liquidations were longer and more wasteful of assets, etc. He further argues that the most effective insurance system were the mutual insurance systems of the 19th century where banks joined a clearinghouse and monitored each other.

Moreover the adoption of deposit insurance by the Federal government was the result of the political muscle of the small banks that opposed branch-banking. My guess is that if Congress had adopted branch-banking in 1933 instead of deposit insurance we might have avoided the S&L debacle and the failure of over 3000 banks in the 1980s(asset restrictions on S&Ls and Reg Q were contributors to the initial problem but deposit insurance multiplied these problems by a huge factor).

I also remember an article of yours over at TechCentral entitled "Fragility by Design" where you argued that centrally designed systems tend to be very fragile. Calomiris provides evidence for deposit insurance on that point in the article I cited above. So why do you support deposit insurance?

George Berger writes:

Arnold,

One of your commenters suggested that free banking might be a good alternative to our current system--i.e. banks would be self-regulating.

I haven't seen you post anything on that. I would be interested to learn what you think about free banking so maybe you could do a post or two on that topic eventually.

Thanks for sharing your thoughts on the financial mess--I have learned a great deal from reading your posts. Keep up the good work.

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