Johnson and Kwak hit the big time: a Washington Post column on the anniversary of the Lehman failure. Like most people, they take the position that letting Lehman fail was a mistake. It is a curious read side by side with Cochrane and Zingales’ Wall Street Journal piece, which includes this blast from the already-cloudy past:
![[Cochrane Chart]](http://s.wsj.net/public/resources/images/ED-AK170_Cochra_D_20090914193552.jpg)
Note, as they do in the article, that the S&P 500 was higher on September 19, 2008, than it was on September 12, 2008.
Johnson and Kwak are thoughtful people, and their honest exploration leads to some interesting observations:
While we support giving the government [resolution] authority, it is questionable what impact it would have on market behavior. Resolution authority carries a meaningful threat only if market participants believe the government would actually use it in a way that harms shareholders and creditors . . . and the government has just spent months insisting that harming either shareholders or creditors is a mistake…
If moral hazard cannot be effectively minimized, then the alternative solution is stricter regulation. That is, instead of trying to create the right incentives for private-sector actors to do the right thing, the government would have the power to simply demand that they do the right thing — or, at least, that they not do the wrong thing.
Wait a minute. We recognize that
- There is a large and growing issue of moral hazard in the financial sector, particularly the Too Big To Fail group;
- The government has shown no ability, at the moment of truth, to confront the financial sector in ways that would penalize the sector’s stakeholders
and the conclusion is that the government should try to regulate more? If the government cannot take action against an insolvent company – as Citi, for example, surely was and would be again without government guarantees – why on earth would anyone expect the government to have the will to push around a healthy company?
In my post about regulatory reform, which James Kwak kindly referenced, most of the attention was given over to defining what firms would be Boring and what firms would be Exciting. But that debate aside, I should probably have done a better job advocating the important concept that whatever firms are Too Big To Fail or otherwise systemically important should lose control over their accounting and be required to obtain all of their long-term capital in a fashion that automatically converts to equity in the event of a capitalization deficiency.
If a deteriorating situation at Lehman had automatically led to the conversion of debt into equity, the question of “should the government intervene” would have been very different. There would already be a solution in place; the government would be faced with “should we intervene to prevent the senior creditors from owning the whole thing.” Every firm would, to some extent, go through a modified bankruptcy every time it hit the capital adequacy threshold, only with an automatic prepack to completely eliminate the uncertainty.
When a company is operational – and especially when the company is operational and large – the tendency is to keep it that way. We were much more willing to intervene to preserve existing jobs at Chrysler than we would ever be to create new jobs building wind turbines. Given the choice between affirmatively signing a document that revokes a systemically important firm’s banking license and casts it into the abyss and spending taxpayer dollars, the government will simply spend taxpayer dollars.
The default needs to be changed. The baseline scenario, so to speak, should be that the creditors are squeezed progressively. In this method, there is no Zero Hour where the firm calls the judge and fails; rather, the failure is slow and deliberate, and the enterprise only gives up the ghost when all of its credit has been exhausted and even then it is not able to maintain capital adequacy standards.
StatsGuy offers this Baseline comment:
Our financial system is like a spinning top – so long as it doesn’t slow down, it’ll stand up, but if it starts to slow down it wobbles, and then it falls.
It is a great summary of the prevailing view of the Bernanke/Summers/Geithner team, and it is also a concise definition of a bubble. I was never a gifted scientist, but I’m pretty sure thermodynamics tells us we cannot have perpetual motion machines. The spinning top that amuses the child requires a regular injection of outside energy to maintain its apparent elegant balance. As a societal matter, we cannot have such a rogue black hole floating through the economy; not finance, not health care, no sector can be allowed to expand without bound on the principle for fear of the difficulty explaining our problems to the public
Joseph Stiglitz, the Ezra Pound of economists:
In the U.S. and many other countries, the too-big-to-fail banks have become even bigger,” Stiglitz said in an interview today in Paris. “The problems are worse than they were in 2007 before the crisis.”
On this particular topic, he and Johnson and Kwak and Cochrane and Zingales all seem to agree (from Johnson):
The largest financial institutions have to be made smaller — aim to make them under $100bn in assets, roughly the size of CIT Group which even this Treasury was willing to leave to its own devices. We can do it with legislation now or by regulatory fiat next time the behemoths get into trouble, but we should do it before they ruin us.
And here I was only looking to split universal banks in two…a government that could split up the finance industry into such small slices would be a government that did not need to worry about moral hazard; there would be no doubt about its resolve. I don’t know if such a government exists, but surely nowhere near DC. And such a plan, even if the will to implement it could be found, would lead to the loss of American firms (and American jobs and taxes) from the cross-border finance world. Seems a shame to trade a clear separation of regulated and unregulated functions, with large institutions still global powerhouses, for lots of tiny universal banks with tiny prop trading desks blowing up tiny balance sheets.
Hi Taunter. Sorry I’m late. Really busy today.
Anyway, as a lowly insurance coverage lawyer, I’ve always hated the term ‘moral hazard’ as espoused by the idiot MBA class. Those of us in the insurance biz make a distinction between “moral hazard” and “morale hazard”.
Wiki has a good 2 sentence explanation:
“In insurance analysis, morale hazard is an increase in the hazards presented by a risk arising from the insured’s indifference to loss because of the existence of insurance. Insurance analysts distinguish this from moral hazard, which they define as an increase in hazards due to risk without any conscious or malicious intent to cause a loss.[1] The use of the term in this way dates back to at least 1968, when it was used in fourth edition of Casualty Insurance.”
To those who might quibble as to a distinction without a difference, I would say it is a huge problem as to INTENT. To paraphrase, a mistake as to excessive risk and pricing of that risk because of inadequate information is a moral hazard. Hence, a common problem for a ‘boring’ company. On the other hand, willingly accepting a hazardous risk, but knowing that it is backstopped by the gov’t. is a morale hazard. It is a KNOWING and INTENTIONAL risk that ‘exiting’ companies engage in.
This is the most infuriating thing about our current crony capitalist system. What’s the point of playing if our nominal gov’t. ‘thumb’ is on the scale for the big boys? No thanks. I’m not playing the 401k game anymore.
In both cases, however, isn’t the issue that the insured doesn’t really care?
Suppose I find a beautiful spot to build a house. It is right on the windward coast of Florida. People tell me I’m crazy; next hurricane I’m going to be picking pieces of my living room table out of the pool. But then the government comes and tells me it will provide subsidized coverage such that my final insurance bill will be no different than if I built on high ground well inland.
So I build my house. Now, I don’t want a hurricane. I’m not trying to create one; not fun to deal with. But now I care a lot less about a hurricane. If one comes, the government will replace my house, and at least I’ll get to enjoy it in all the non-hurricane years. Building inland means I never get the oceanfront fun.
The folks who trade CDS don’t think their products will blow up. Many are so confident they will make money that they clamor to invest personally. Problem is, they are playing with fire. Where is the desire to push back, if when that perfect storm comes the government rushes to your aid. On all the sunny days you make money. Maybe the rain will never come. And if it does, after all the hassle of going through it, you come out rested, rich, and happy on the other end.
What kind of hazard is that? Because that’s the one we have.
Taunter: And here I was only looking to split universal banks in two…a government that could split up the finance industry into such small slices would be a government that did not need to worry about moral hazard; there would be no doubt about its resolve. I don’t know if such a government exists, but surely nowhere near DC.
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If you have big Exciting Finance businesses, the regulators will bail them out unless you impose the individual regulators involved face personal criminal liability doing so. For example, in the Clinton years, Larry Summers and Tim Geithner asked Congress for money to bail out Citi and other NY banks for bad loans to Mexico. Rank and file congressman Bernie Sanders and others led a revolt against Congressional leadership that denied Summers and Geithner the money, so they arguably mis-used the Exchange Stabilization Fund to give wall street the money any way. You also need executives to face personal criminal liability for lobbying for a bailout, or they will try for one.
Small firms inside the US can be protected from foreign big banks by outlawing their use of branch/office ops in the US, and requiring them to operate through US corporate subs, and then placing limits on the size and activities of those subs comparable to those faced by the Boring or Exciting firms in the same businesses. And small firms can operate cross-border. Lots of firms that aren’t global operate globally using network relationships. There’s no reason banks can’t do the same.
Also, I hope you saw the Financial Times article arguing for protectionist tactics against China. It was written by Clyde Prestowitz, who generally supports free trade. http://www.econstrat.org/index.php?option=com_content&task=view&id=373&Itemid=59
What you are saying is that regardless of the law, the executive branch will do what it wants to do. That may be true; Robert Moses made a career of it. But there is no real defense against this. It’s a bit like positing what would happen if a President refused to leave at the end of his term: it would come down to whether the military stayed loyal or not. Once you believe your government runs exclusively by force, you are in a banana republic.
My point about small firms was not their protection within the United States but their opportunities outside it. If JPMorgan or Goldman Sachs were shrunk to the size of CIT (the Baseline proposal), these firms would have a significant disadvantage competing for, say, underwriting Vodafone bonds. UBS or Deutsche would be much better positioned.
Taunter,
I think there is a time honored way of forcing the Executive Branch personnel to obey the law: prison time. Congress got pissed off about IRS personnel breaking the law by abusing taxpayers, so they passed a statute imposing prison time if they do so. Congress got pissed off about Nixon doing IRS audits of people, so it passed a state imposing prison time if White House personnel request an audit by the IRS. Congress ought to do the same thing for treasury and federal reserve personnel; make them face personal criminal liability for doing bailouts.
I don’t care if GS or JPM lose out on foreign IPOs. Their ability to do that is not worth risk of having to give them taxpayer funded bailouts. I consider the debt incurred to bail out the banks odious debt. I think Ireland and Iceland and other countries ought to have refused to pay it.
I hope there are riots and civil unrest and vigilante attacks on bank executives. I think that will lead to criminal prosecutions of bank executives responsible for the bailouts. I am not sure what else will.
Interesting you mention using the IRS, since we have been on the edge of that one already. But note that Federal prosecutions emanate from the executive branch; if you believe that the government will simply go rogue, even that is no protection. Ultimately, you pass the regulations you believe best and have to hope that the sense of unity and national purpose among the government agencies will force some level of compliance.
As for the riots and civil unrest and vigilante attacks on bank executives, I completely and utterly disagree with you. Not only am I against riots and civil unrest and vigilante attacks on anyone, it hardly makes sense to pick on the bank executives for asking for hundreds of billions of dollars with no restrictions; the fault rests with the government that provided it.
Lookit, Summers, Geithner, Bernanke, and bank executives have been forcing the federal governemnt to assume debt incurred by bankers just like in a banana republic. If Summers and co want to play by banana republic rules, they invite the public to do the same. I hope Summers doesn’t force the people to resort to violence against politicians and bank executives, but I fear he will. He is stubborn and corrupt.
As for the bank executives, every bubble I have studied involved massive criminal offenses by bank executives. I find it difficult to believe this one was any different. If Holder won’t punish the NY big bank executives for banking and securities violations (if any), Holder is playing by banana republic rules and he is invititing the public to do the same.