I’m back from a long blogging-vacation. I also find myself in the odd position of returning to the NY Fed to do some work on the financial crisis for a few months, so let me take this opportunity to take back all the bad things I said about the place in my previous posts. I’m reassured that the good people in corporate intelligence haven’t linked this blog with my identity, a fact that most likely results from my lack of readers. I now consider this a blessing. So if you are reading, consider yourself amongst a privileged (or, perhaps, unfortunate) few! (To the large number of Russian commentors on this blog, thanks for your thoughts, but I don’t speak Russian!)
The past few months have witnessed the rapid receding of populist fervor and the predictable, if depressing, return of financial industry lobbying power. This has resulted in the end of mark-to-market accounting, the announcement of perhaps one of the biggest acts of theft in human history, known as the PPIP, and a general commitment to the principle that government funds should be used to preserve the financial services industry in its current form, more or less. For a depressing log of the depressing developments, go no further than the good people at baselinescenario.com (a special thanks to James Kwak for including my comment on Tim Geithner’s massive but unsuitable intellect in one of his posts).
A cynical commentator, like those at Baseline Scenario, may assert that Obama’s commitment to Big Finance is a dead-weight loss for us all (e.g. http://baselinescenario.com/2009/05/25/what-good-is-it-anyway/) and amounts to something close to corruption. Some of the main arguments along this line attack the “too-big-to-fail” formulation (e.g. here, and here), while others have attacked the norms of big finance and externalities their risk taking imposes on the broader economy (e.g. the thoughts of the great Martin Wolf). The moral hazard-producing activities of the Fed, in particular, have been criticized for amounting to a permanent backstop for the excessive and supremely irresponsible risk-taking of big banks, all for the purpose of preserving outsized profits for the hopelessly narcissistic and ultimately talentless individuals who make up the financial sector (e.g. here, here and, most importantly, here (specifically anti-Fed here and here)).
Hysteria in the face of corruption may be justified, even if it’s the soft kind of corruption, but we Americans hate hysterics (somebody needs to tell this to the GOP), so, contrary to all the commentary linked above, I’d like to venture to make a case for what amounts to the Obama approach. One thing I think everyone can agree on is that Obama is a consummate conservative: his impulse is always and everywhere to work with existing institutions and stakeholders to find some common ground. Whether or not his apparent commitment to the big banks amounts to his underwriting of a welfare thesis in favor of Big Finance, or is simply the by-product of his underlying conservatism, is debatable (see here for a discussion of how the nationalization debate played out).
In any case, at the risk of sounding insane, allow me to develop here and in the next few posts a set of welfare theses in favor of the preservation of Big Finance. This amounts to ascribing a master plan to what has looked like a lot of muddling through by both the Obama and Bush administrations, which is probably an exercise in folly; but, then again, this is probably the world we will live with going forward, so its contours should be identified. I call them the welfare theses of Princely Capitalism:
-Big banks engaging in several lines of business provide efficiencies that cannot be gained otherwise. By allowing information flows between e.g. loan origination and proprietary trading, banks make outsize profits, but also produce efficiencies in the allocation of capital. As such, regulations such as anti-trust that could prevent the “too big to fail” phenomenon, or taxes that could cause banks to internalize the costs of the externalities produced by their risk-taking (see the Martin Wolf piece above), will cause an overall loss of efficiency in the economy that outweighs the costs imposed by the current system.
A more succinct way of saying this: big banks produce returns to scale for their investors, and efficiencies in financial intermediation.
-Securities market–based financial intermediation provides for better risk management practices than the old form of bank-intermediated finance, possibly by reducing the problem of loan monitoring to a purely quantitative exercise. The package and sell model for loans (“securitization”) leads to higher levels of credit provision, which improves economic outcomes.
Notes: the current crisis can be seen as a symptom of a long process whereby securities markets overtook the functions of loan-monitoring and risk management that used to be performed by loan officers at banks. In Princely Capitalism, this “shadow banking system”, with its teams of quantitative analysts and traders, overtakes the more people-driven world of the loan officer (from George Bailey to Gordon Gekko). One welfare thesis of Princely Capitalism is that this system is unqualifiedly better than the old system, since it allows for better pricing and sharing of risk.
-A cycle of boom followed by bust followed by government bailout may produce undesirable economic volatility and socialization of banking losses, but the alternative of less risk taking and lower provision of credit is outweighed by the benefits of the new system. Thus, the “asymmetric payoffs” that accrue to the banking sector–heads they win, tales the public looses–may sound bad, but the alternative of less risk taking and lower credit provision is far worse. In Princely Capitalism, finance enjoys all the benefits of being a public utility, with none of the restrictions.
-Over-the-counter markets should not be curtailed, lest financial innovation be retarded. (See here for a discussion of some of the current issues regarding OTC markets.) Financial innovation is the activity whereby risk is more accurately priced through the creation and trading of new securities and lending/borrowing structures; this pricing of risk allows for better hedging of risk by market participants, leading to overall efficiency gains in the allocation of capital. Forcing derivatives trading onto exchanges will retard “innovation” through a regulatory chilling effect, leading to efficiency losses for the broader economy.
-Securities markets are hyper-rational: the incentives generated by pay structures for professional market participants have no bearing upon financial intermediation in general. Markets will err towards rationality in pricing regardless of the motivations of market participants.
Notes: Nassim Taleb, among others, has argued against the call option most traders receive as compensation. In other words, your average trader shares in all the upside and none of the downside. Given quarterly bonuses paid to traders, this results in short-termism: traders who take large short-term risks can reap rewards and be out the door before their bets fail in the long-term. In Princely Capitalism, however, it is acknowledged that these incentive structures are not in-and-of-themselves determinative of trading decisions.
-Following from a few of the foregoing proposed welfare theses: lending decisions are best determined through the market-forces of the trading floor, rather than more traditional forms of intermediation.
Above all, the primary welfare thesis of Princely Capitalism:
-Allocation of capital is an activity best suited to a group of highly-educated individuals trained primarily in quantitative modeling and located in centralized financial centers, rather than to qualitative, people-driven assessments of lending opportunities by regionally dispersed individuals close to the geographic areas they’re lending in.
These theses are rough and, obviously, some are redundant. I hope to refine them as events develop and the new world comes into view. I invite your comments and refinements.
