Arnold Kling  

Squam Lake or Swamp?

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What happens when you bring leading academic experts in economics and finance together to come up with ideas to prevent future financial crises? You get The Squam Lake report, enthusiastically greeted by Ben Bernanke.

I am not impressed. The report finds the time (an entire chapter, in fact) to address the "need" to regulate how people save for retirement without offering a word of criticism of the policy of promoting home ownership with lenient, subsidized mortgage credit. To me, that indicates how much the report reflects the "insider" point of view and how little consideration it gives to flaws in the political process or the potential for fallibility of regulators.

The authors have the audacity to suggest that a systemic risk regulator would have been able to forestall the problems with Fannie Mae and Freddie Mac. The political reality was that Freddie and Fannie were an unstoppable freight train of powerful lobbying, right up to the point where they were insolvent.

The report is based on two central principles. The first principle is that regulation was too heavily focused on individual institutions, rather than on systemic risk. I think that is way, way, overstated. First of all, the Fed and the IMF were always looking for systemic risks. In this case, they just did not see them. They saw the opposite--a financial system in which innovations had succeeded in reducing risk.

The second principle (p.137)


is that regulators must create conditions that minimize the likelihood of bailouts of financial firms by forcing them to internalize the costs of failure...Many of our recommendations are intended to create a robust financial system in which any troubled financial company is allowed to fail.

If you want to prevent bailouts, the issue is not so much the behavior of bankers as it is the behavior of government officials. For government officials, there is a huge time consistency problem. In the abstract, they will promise never to bail anyone out. In reality, in an actual crisis, they have an overwhelming incentive to break that promise.

In the abstract, it makes sense to vow never to pay ransom to kidnappers. In reality, when someone is kidnapped, you are likely to break that vow. Government officials face that same time consistency problem with bailouts.

The report recommends the contingent capital approach and the "living will" approach to make it easier to resolve troubled banks. However, in the real world, the willingness of government officials to use these mechanisms is likely to be lacking. As Sam Peltzman pointed out at the talk he gave last week, after the S&L Crisis, the government also enacted measures to provide enhanced resolution authority for troubled banks. But when it came to Citigroup and Bank of America, the will was lacking to apply that authority. That is likely to hold in the future as well.

A "living will" suggests that we would, in a crisis, break up too-big-to-fail banks. So the government officials who today are unwilling to break up TBTFs will, in the midst of a crisis, find the courage to do so? Count me skeptical, to say the least.

The authors display considerable faith in technocratic control. Their systemic risk regulator will have God-like powers to assemble and process information. On p. 34-35, they write,


a new information infrastructure is needed for regulators to understand trends and emerging risks in the financial industry. This will require a broad set of financial institutions to report standardized measures of position values and risk exposures. Such information is valueless unless it can be analyzed, and this is a natural function of the systemic regulator.

As I have said before, the Insiders view the financial crisis as a Keynesian moment, requiring more central management from technocrats. Instead, I think it is a Hayekian moment, illustrating the inability of central planners to process increasingly dispersed information. Of the fifteen authors of the report, four are from the University of Chicago, including John Cochrane and Raghu Rajan. But the way I see it, these folks are closer to Keynes than to Hayek.



COMMENTS (8 to date)
david writes:

There is no reason to believe that markets extract dispersed information.

Nico writes:

David- I'd like to hear your argument for that assertion. It seems to be like the Leonard Reed's (sp?) pencil argument makes it pretty clear. How could any technology be possible without this effect. I get that it's not anarcho-capitalism and that the state plays a role, but are you implying that central planning is a good idea?

Arnold- Your critiques are basically good, as always, but I just don't follow you on thinking, as you seem to at least imply, that the tea-partiers offer any hope.

Seems like an effective grassroots solution would have to push for solutions to political economy problems, or change peoples mind on a massive scale. Your break up the banks idea seems good as the former. But the TP's seems just as much old-fashioned right-wing populism as anything Hayekian.

[Leonard Read's original article, is available at I, Pencil on Econlib as well as at the original source, the FEE. Links that lead to full body or chest or other physical displays are not going to happen.--Econlib Ed.]

Tracy W writes:

David, I suppose it depends on your definition of "extract". But the fundamental reason for believing that markets are a good way of making use of dispersed information is that the market economies of the West were far better at supplying people's wants than the planned economies of the Communist countries. There are stories of Russian observers being amazed by the fruit and vege markets in London, asking who planned this, and not believing the answer of "no one".

Another more specific reason to believe that markets do a good job of making use of dispersed information is by looking at what happens when markets are removed. There's an interesting case of onions - onion futures were banned in the USA, and since then onion prices have reportedly been more volatile.
http://www.marginalrevolution.com/marginalrevolution/2008/07/onion-futures.html

david writes:

I was referring to Kling's remark in his last paragraph.

Obviously, central planners can process some information that is initially dispersed; likewise, markets can process some information. The point is the relative strengths of either; Kling's stance is that although we do not know what outcome the market will produce, we should believe is better than the flawed but known outcome regulators can produce. How he compares an unknown to a known is, of course, a mystery...

Recall Coase's insight as to why large firms exist. Internal firm processes can generally be separated. If resorting to the market were more efficient than resorting to a hierarchically subordinate department, then we should observe many, many small firms. And businesses have become larger over time, which suggests that our technical ability to manage dispersed information has in fact improved. If information has become more complex, so has our ability to process it.

This doesn't imply that we are in a position to push everything in the economy to one central planner - which, happily, no-one is proposing. The proposal here is for industry-specific systemic regulators and regulations, not command-and-control nationalized banks. To borrow the concept of Read's pencil, it may be non-economical for any one planner to grasp all the possible ways in which to manufacture a pencil, but it is possible for a regulator to notice that such and such pigments are toxic and hence prohibit their use. Of course, it may be that at some future date pencil factories will adopt some currently unknown pigment that the regulator has failed to notice the toxicity of, but we'll cross that bridge when we come to it, aye?

Chris Koresko writes:

@david: "...it is possible for a regulator to notice that such and such pigments are toxic and hence prohibit their use."

Possible, but wise? This reminds me of the recent shortage of off-road motorcycles that was caused by a Federal regulator banning them because of the risk that children might eat their lead-based paint. Those regulators presumably don't bear much of the cost of those decisions, so their incentives don't generally lead them to make optimal decisions about what type or degree of risk to accept.

Tracy W writes:

The point is the relative strengths of either; Kling's stance is that although we do not know what outcome the market will produce, we should believe is better than the flawed but known outcome regulators can produce. How he compares an unknown to a known is, of course, a mystery...

There are a couple of problems here. Firstly, how do we know what the outcome is that regulators will produce? Isn't this as normally unknown as the outcome of any market action? See for example the argument that vehicle efficiency standards regulations created the SUV - http://www.calgarybeacon.com/2010/06/how-green-regulations-helped-create-the-suv/ I can't see anything in Kling's post where he claimed that the outcome of regulation was known, and I notice that you don't provide any reason to believe that such outcomes are known.

Secondly, did you read my earlier response? The most obvious reason to believe that market outcomes are better than central planning is that the market economies of the West did far better than the centrally planned Communist countries. The dramatic difference drove many leftists to give up their beliefs in the natural superiority of central planning. I am rather surprised that you managed to miss the most important economic message of the 20th century.

Recall Coase's insight as to why large firms exist. Internal firm processes can generally be separated. If resorting to the market were more efficient than resorting to a hierarchically subordinate department, then we should observe many, many small firms.

What you miss in your account of Ronald Coase's insight is that there is a balancing act. Sometimes it is more efficient to resort to the market, sometimes it's more efficient to resort to a hierarchically subordinate department. In some places we observe many small firms, in other situations we observe large firms. In a market system, where people are free to contract, we should see some convergence on which set ups work better for particular industries at a particular point of time (obviously underlying technologies change, industries mature, eg computer chips becoming a commodity, etc, which changes the nature of the "right" mix). A regulator however is not subject to these market forces, you can't conclude from the example of large firms that regulators can escape the constraints of knowledge.

And businesses have become larger over time,

An interesting claim, what is your source? I didn't know there were any time series on firm sizes going back several decades, and would be delighted to find out about them.

The proposal here is for industry-specific systemic regulators and regulations, not command-and-control nationalized banks.

Indeed, and industry-specific systemic regulators are subject to the same knowledge problems as central planners, and even worse, being industry-specific they face even more difficulty taking account of the effects of other regulators' actions on their own industries, or the effects of their regulations on other industries.

but it is possible for a regulator to notice that such and such pigments are toxic and hence prohibit their use

Indeed, it is possible. What is not possible is for regulators to work out the full impacts of the effect of such a prohibition.

JW writes:

Arnold,

You are old enough to remember that Citi was bailed out (by regulatory forbearance or monpol) in both the '80s (Latam debt) and '90s (CRE) in addition to 2008. As you note, bailouts have nothing to do with law and everything to do with political expediency. This is why the debate over "ending TBTF" via the Dodd bill is a red herring.

Regards, JW

Amit Sarkar writes:

Arnold:

Having spent most of my professional life on Wall Street as a career investment banker, I can tell you that this report is complete garbage. Either these professors don't have a clue as to how Wall Street operates in real life, or (more likely) they are being less than honest in justifying our politicians forcing Main Street to bail out Wall Street fat cats with trillions of dollars we do not have.

Nobel Laureate economist Joe Stiglitz calls it greatest reverse transfer of wealth in human history. The mickey mouse "solutions" they offer, and Prof. Schiller pontificates about in NY Times today, are not worth the paper they are written on.

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